The Demand for Money in an Open Economy: the Case of Malaysia

The purpose of this paper is to estimate the demand for money in Malaysia over the 1980:1-1994:10 period using cointegration and error correction methodology. The analysis shows that money balance, income, exchange rate, price and interest rate are cointegrated. Thus, the long- run demand for money balances for M1 is specified and estimated by using Johansen and Juselius Maximum likelihood cointegration method. The calculated errors from the long run money demand for M1 are then used in the error correction model of M1 demand. Hendry and Ericsson's general to specific procedure is used to reach the final form of the short-run dynamic demand for money. The explanatory variables that influence the money demand (M1) in the short run are income, expected inflation rate, 6-months mode deposit rate, expected rate of change of exchange rate, seasonal dummies, and the error correction from the long-run demand for money. Chow test shows that the estimated demand function remains stable over the 1980:1-1994:10 period. The findings, also, indicate the presence of currency substitution in Malaysia.