LONG-RUN MONEY DEMAND IN THE NEW EU MEMBER STATES WITH EXCHANGE RATE EFFECTS

WO R K I N G PA P E R S E R I E S
N O 6 2 8 / M AY 2 0 0 6
LONG-RUN MONEY
DEMAND IN THE NEW
EU MEMBER STATES
WITH EXCHANGE RATE
EFFECTS
ISSN 1561081-0
by Christian Dreger,

Hans-Eggert Reimers
9 7 7 1 5 6 1 0 8 1 0 0 5
and Barbara Roffia

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W O R K I N G PA P E R S E R I E S
N O 6 2 8 / M AY 2 0 0 6
LONG-RUN MONEY
DEMAND IN THE NEW EU
MEMBER STATES WITH
EXCHANGE RATE EFFECTS 1
by Christian Dreger 2,
Hans-Eggert Reimers 3
and Barbara Roffia 4
In 2006 all ECB
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1 Useful comments by F. Smets, by attendants at the ECB seminar and by an anonymous referee are gratefully acknowledged. The
views expressed in this paper are those of the authors and do not necessarily reflect the views of the European Central Bank, of
the Institute for Economic Research Berlin and the University of Technology of Wismar.
2 German Institute for Economic Research (DIW) Berlin, 14191 Berlin, Germany; e-mail: cdreger@diw.de
3 Hochschule Wismar, University of Technology, Business and Design, PF 1210, 23952 Wismar, Germany;
e-mail: h.reimers@wi.hs-wismar.de
4 Directorate General Economics, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany;
e-mail: barbara.roffia@ecb.int

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C O N T E N T S
Abstract
4
Non-technical summary
5
1
Introduction
6
2
Money demand of transition countries
8
3
Data description
10
4
Panel unit root tests
12
5
Cointegration tests
13
6
Conclusions
16
7
References
17
8
Appendix: figures and tables
21
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Abstract: Generally speaking, money demand models represent a natural benchmark
against which monetary developments can be assessed. In particular, the existence of a
well-specified and stable relationship between money and prices can be perceived as a pre-
requisite for the use of monetary aggregates in the conduct of monetary policy. In this study
a money demand analysis in the new Member States of the European Union (EU) is con-
ducted using panel cointegration methods. A well-behaved long-run money demand rela-
tionship can be identified only if the exchange rate as part of the opportunity cost is in-
cluded. In the long-run cointegrating vector the income elasticity exceeds unity. Moreover,
over the whole sample period the exchange rates vis-à-vis the US dollar turn out to be sig-
nificant and a more appropriate variable in the money demand than the euro exchange rate.
The present analysis is of importance for the new EU Member States as they are expected
to join in the future years the euro area, where money is deemed to be highly relevant ?
within the two-pillar monetary strategy of the European Central Bank (ECB) ? in order to
detect risks to price stability over the medium term.
Key words: Money demand; new EU Member States; exchange rate; panel cointegration
JEL classification: C23, E41, E52
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Non-technical summary
Generally speaking, money demand models represent a natural benchmark against which
monetary developments can be assessed. Therefore, having a stable long-run money de-
mand is very important, as the existence of a well-specified and stable relationship between
money and prices can be perceived as a prerequisite for the use of monetary aggregates in
the conduct of monetary policy. The stability of this relationship is usually assessed in a
money demand framework, where money demand is linked to other macroeconomic vari-
ables, like income and interest rates.
In this study, a money demand analysis in the new Member States of the European Union
(EU) is conducted using panel cointegration methods. Given the history of these countries
which, during periods of high inflation, have been experiencing a partial replacement of
domestic by foreign currencies, we also include in the money demand equation ? in addi-
tion to standard macroeconomic variables such as money, income, prices and interest rates
? the exchange rate variable.
The results from the empirical analysis show that a well-behaved long-run money demand
relationship can be identified only if the exchange rate ? as part of the opportunity cost ? is
included. In the long-run cointegrating vector, the income elasticity exceeds unity. More-
over, the exchange rates vis-à-vis the US dollar turn out to be significant (with a negative
sign) and tends to be a more appropriate variable in the money demand than the exchange
rates vis-à-vis the euro. The importance of the US dollar exchange rate is in line with previ-
ous findings in the literature focusing on individual new Member States. Moreover, it might
be possibly due to the fact that the launch of the euro exchange rate in January 1999 seems
to have affected only a few exchange rate regimes in the new Member States (although
sometimes at a later stage), while before 1999 it was constituted by its legacy currencies.
The present analysis is of importance for the new EU Member States as they are expected
to join in the future years the euro area, where money is deemed to be highly relevant ?
within the two-pillar monetary strategy of the European Central Bank (ECB) ? in order to
detect risks to price stability over the medium term.


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1. Introduction
Money demand models represent a natural benchmark against which to assess monetary
developments. As a matter of fact, they can provide a framework which helps to distinguish
between those changes in money which are explained by developments in macroeconomic
variables and those changes which are specific to the situation at hand. Therefore, having a
stable long-run money demand is very important, as the existence of a well-specified and
stable relationship between money and prices can be seen as prerequisite for the use of
monetary aggregates in the conduct of monetary policy. The stability of this relationship is
usually assessed in a money demand framework, where money demand is linked to other
macroeconomic variables like income and interest rates.
The present analysis focuses on estimating a long-run money demand function for the ten
new Member States ? eight Central and Eastern European countries and two mediterranean
countries ? which, in May 2004, have entered the European Union (EU). In addition to the
variables which are usually considered within money demand analysis (e.g. income, prices
and a measure of the opportunity costs), in the period of transition foreign determinants can
also play a crucial role in explaining money demand. In the specific case at hand, during
periods of high inflation, the Central and Eastern European countries experienced a partial
replacement of domestic by foreign currencies, either as a store of value or a medium of
exchange. Therefore, the exchange rate is likely to be an important factor explaining money
demand behaviour in these states. As the euro was not introduced before 1999, the euro and
US dollar exchange rates are therefore considered alternatively in the analysis.
In order to estimate long-run money demand functions for the new EU Member States,
cointegration techniques are employed (see, for example, Engle and Granger, 1987). As
most countries are transition economies, they have to manage enormous structural changes.
Hence, it is difficult to obtain data for a long sample period. The estimated parameters,
which are based on a short period, are not very reliable. Evidently, estimates for long-run
parameters require data for a long period. Alternatively, the sample can be extended, if the
information of all countries is pooled. This is done by panel integration and cointegration
techniques (see Banerjee, 1999). Specifically, the procedures of Pedroni (2000), Mark and
Sul (2002) and Breitung (2002) are used to get efficient estimates of the cointegration pa-
rameters.
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The results indicate that a well-behaved money demand function can be justified only if the
exchange rate is allowed to enter the specification. In reduced systems containing money,
income and interest rates, a long-run relationship cannot be detected at all. This principal
finding is confirmed when the exchange rates vis-à-vis the euro are part of the variables set,
possibly due to the late introduction of this currency. Only if the exchange rates vis-à-vis
the US dollar are considered, cointegration can be found. Moreover, the income elasticity
seems to be significantly larger than 1.
The present analysis is of importance for the new Member States of the European Union
(EU). As a matter of fact, they have joined the EU as Member States with a derogation.
This means that, while not yet adopting the euro, they will be committed to striving towards
the eventual adoption of the euro after having at some point following accession, joined the
exchange rate mechanism (i.e. ERM II). The adoption of the euro will occur upon fulfil-
ment of the convergence criteria laid down in the Maastricht Treaty. These conditions in-
clude ceilings for inflation and long-term interest rates, budget deficits and government
debt and exchange rate stability. After the introduction of the euro, the Governing Council
of the European Central Bank (ECB) will also take over the responsibility of the monetary
policy for these countries.
Given that these countries are expected to join in the future years the euro area, money de-
mand analysis of the new EU Member States will soon become more relevant as money is
deemed to be highly relevant ? within the two-pillar monetary strategy of the ECB ? in or-
der to detect risks to price stability over the medium term.2
The rest of the paper is organised as follows. Section 2 gives the specification of the long-
run money demand function. Section 3 illustrates the macroeconomic developments in
these countries and describes the set of variables used in the analysis. The following two
sections present the econometric methods and the corresponding results for the unit root
testing and the cointegration analysis respectively. Finally, concluding remarks are pre-
sented in Section 6.

2 In 1998, the Governing Council of the ECB (1998) announced the main elements of its monetary policy strategy,
which is based on a two-pillar framework. Within the first pillar, the monetary aggregate M3 was attributed a promi-
nent role. On 8th May 2003 the Governing Council of the ECB reviewed and confirmed the two-pillar monetary policy
strategy (ECB 2003), whereby one pillar is based on the economic analysis of price risks in the short term, while the
other pillar includes the monetary analysis of risks to price stability in the medium term and long run, with the mone-
tary aggregate M3 still having a prominent role.
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2. Money demand of transition countries
In the literature there are only a few studies which analyse money demand functions in
transition countries (see Buch, 2001). Earlier investigations cover only a short period of re-
form years (Dzwonik-Wrobel and Zieba, 1994, International Monetary Fund, 1998). Based
on a correlation analysis, Antczak (2003) and Jarocinski (2003) have stressed the impor-
tance of money growth for stabilizing inflation rates. More recently, Buch (2001) has speci-
fied money demand functions for Hungary and Poland, which account for the transition
situation of these countries. Her money demand function includes an income variable, do-
mestic and foreign interest rates and changes of exchange rate expectations as well as infla-
tions rates. Hence, this implies more than one variable measuring opportunity costs of
money holding. The importance of exchange rates is also stressed by Orlowski (2004) for
Hungary, Poland and the Czech Republic as well as by Komarék and Melecký (2001) for
the Czech Republic.
The analyses of money demand functions for the euro area do not contain more than two
opportunity cost variables (see, for example, Görgens et al., 2004, Bruggemann et al.,
2003). Those studies suggest the following functional form for the money demand function:
(1)
M / P = f (Y,oc)
where M represents a broad monetary aggregate, P is the consumer price index (which may
be either the HICP for the euro area or, more generally, the CPI or the GDP deflator), Y is
income proxied by the real GDP, and oc represents an opportunity cost indicator. Accord-
ing to textbook presentations, the income variable should have a positive effect on money
holdings. Conversely, if the opportunity cost measures the earnings of alternative assets, its
coefficient should be negative.3 The interest rate variable includes via the Fisher effect the
inflation rate of these countries (see Orlowski, 2004). At least for most industrial countries,
Crowder (2003) finds evidence in favour of the Fisher effect using panel cointegration
methods.
With the exception of Poland, all the other new EU Member States are “small” open
economies. The foreign trade liberalisation during the transition process has, therefore, af-

3 As will be explained later, due to the developments of the financial markets of the new EU member states,
the opportunity costs are approximated by the short-term interest rate.
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fected agents’ behaviour with respect to their demand of foreign and domestic financial as-
sets. Agents could switch more easily between foreign and domestic currencies. This may
have affected money holdings in these economies. In order to account for this effect (which
is usually denoted as “direct currency substitution” effect), the exchange rate (i.e. its rate of
appreciation/depreciation) may be used as a proxy for the rate of return on foreign money.4
In the literature on money demand, many studies (e.g. Buch, 2001 and Orlowski, 2004) in-
clude in the money demand function of some of the new EU Member States also the ex-
change rate against the euro. However, the overall effect of the exchange rate on money
holdings is not entirely clear-cut. On the one hand, in a monetary model of the exchange
rate, a depreciation of the domestic currency is likely to induce extra demand for domestic
goods from abroad and the induced rise in domestic production implies higher domestic
inflation rate and a need for more money in the economy as the amount of transactions in-
creases (see, for example, Bilson, 1979 and Komárek and Melecký, 2001). Hence, being the
exchange rate denoted as units of domestic currency per unit of the foreign currency, its
coefficient should be positive. On the other hand, according to the currency substitution ap-
proach (see. e.g., Calvo and Rodriguez, 1997), a depreciation reduces the confidence in the
domestic currency, thereby lowering money demand via a substitution effect with foreign
money. Hence, its coefficient should be negative. This is also true if the exchange rate vari-
able reflects the main source of returns in the foreign currency holdings. Selcuk (2003) pre-
sents evidence that some of the new EU Member States have a considerable proportion of
foreign currency holdings.5
Moreover, devoting some attention to the analysis of the effect of the exchange rate on
money demand is also important as these countries ? in view of the fact that they are ex-
pected to join the euro area some time in the future ? are likely to focus on minimising the
volatility of the domestic currency value against the euro. As a matter of fact, some of the
new EU Member States have already given the exchange rate policy a prominent role in
implementing their monetary policy aims; therefore, its importance should be taken into
account in the study (see Backé et al., 2004). For example, Estonia introduced a currency
board to the euro in 1992. Malta followed a currency basket peg since 1971, where the

4 As an example, the expected rate of return non-foreign money can be represented by the expected depre-
ciation of the domestic currency relative to the foreign currency.
5 In the present analysis we follow the direct currency substitution approach.
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Document Outline

• Long-run money demand in the new EU Member States with exchange rate effects
• Contents
• Abstract
• Non-technical summary
• 1. Introduction
• 2. Money demand of transition countries
• 3. Data description
• 4. Panel unit root tests
• 5. Cointegration tests
• 6. Conclusions
• 7. References
• 8. Appendix: figures and tables
• European Central Bank Working Paper Series

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