Lessons from Stability of Money Demand for Monetary Policy

Document Type : Research Paper

Authors

1 PhD Economics, Central Bank of Iran, Tehran, Iran,

2 Professor, Faculty of Economics, University of Tehran, Tehran, Iran

Abstract

This paper shows that the quasi-money (QM) demand function and thus the M2 demand function are unstable, which may arise from the innovations in the banking system. Since the early 90s, the deposit interest rate has increased and innovations in the banking system have changed long-term deposits to an instrument for saving and modified the nature of QM. As a result, QM became a direct function of interest rate (yield), and it has distinguished itself from money as a medium of exchange. However, M1 demand is stable and an inverse function of interest rate, which emphasizes it as the demand for the medium of exchange.
These results have important implications for designing the monetary policy framework and prerequisites for its success. The substantial difference between M1 and QM precludes M2 as an appropriate money definition. Therefore, despite its widespread use in analyses, M2 growth is misleading, especially as an inflation predictor. The rise in QM growth because of an interest rate increase is an issue outside the scope of monetary policy, and it should be examined from the financial stability perspective. In other words, QM growth is not a risk to price stability, as long as the banking system can withstand the interest rate risk. If the banking system is stable financially, the central bank could successfully implement a rate-based monetary policy framework
JEL Classification: E41, E52

Keywords

References

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Journal of Economic Research (Tahghighat- E- Eghtesadi)
Volume 57, Issue 2 - Serial Number 139
January 2023
Pages 259-284

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History

  • Receive Date: 17 October 2022
  • Revise Date: 10 December 2022
  • Accept Date: 24 December 2022

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