The demand for money and the real exchange rate misalignments in emerging European countries: A nonlinear approach

Abstract

This paper investigates the extent to which domestic and foreign money balances in emerging European countries are influenced by foreign exchange considerations. A well-specified and stable relationship between real money demand and the exchange rate can be perceived as an important part of a successful monetary policy. This study examines the long-run determinants of real exchange rates (RERs) associated with the behavioral equilibrium exchange rate (BEER) approach and identifies currency misalignments in these countries. The misalignment is later used to test the nonlinear behavior of the demand for money. The results indicate that the RER misalignments have a significant impact on domestic money demand. When the currencies are overvalued, there is a reduction in domestic money demand, and when they are undervalued, there is an increase in domestic money demand. Furthermore, it can be concluded that overvaluation causes an increase in foreign money demand indicating a shift of preference from domestic to foreign currency.