The Demand for Money in Malaysia : A Cointegration and Error Correction Model

The main purpose of this study is to estimate the demand for money (M1 and M2) in Malaysia using quarterly data over the period of 1982:1 to 1998:2 using recently developed econometric techniques of cointegration and error correction methodology. To take into account the effect of Asian Financial Crisis in mid 1997 on the behavior of the demand for money in Malaysia, the sample period is divided into two sub-samples: 1982:1 to 1996:4 and 1982:1 to 1998:2. The results provide evidence that the crisis somewhat affect the behavior of the money demand. The results of the study also show that the real money balances, real income, money’s own rate of return, the rate of return of alternative assets, stock prices, expected exchange rate depreciation and foreign interest rate are cointegrated. Thus, the long run demand for real money balances for Ml and M2 are specified and estimated by using Johansen’s cointegration method. Later, the calculated error terms from the long run money for Ml and M2 are then used in the error correction model of Ml and M2 respectively. The Hendry’s general to specific procedure is used to reach the final form of the short run dynamic demand for M1 and M2. The results show that the variables that influence the demand for Ml in the short run are real income, money’s own rate, stock prices, the expected exchange rate depreciation, seasonal dummy and the error correction term from the long-run demand for M1. On the other hand, the variables that influence the demand for M2 in the short run are real income, the rate of return of alternative assets, expected exchange rate depreciation, foreign interest rate, seasonal dummy and the error correction term from the long run demand for M2. Finally, the result of the CUSUM and CUSUM of Squares test suggest that the estimated demand functions remain stable over the 1983:2 to 1998:2 period in spite of the financial liberalization and innovation process that the Malaysian financial system has been experiencing. The findings also indicate the presence of currency substitution in Malaysia during the study period.