Structural Breaks, Cointegration and the Demand for Money in Greece

This paper investigates whether stable long-run money demand function for real narrow money exists in Greece over the period 2001:Q1-2010:Q4. To achieve this objective, the Johansen maximum likelihood procedure is used. Then, Gregory and Hansen tests are applied to test the possible structural breaks in money demand functions. To examine the existence of seasonal unit roots in quarterly data, the Hylleberg, Engle, Granger and Yoo (HEGY) test is used. The estimated results from the Johansen procedure show that there is no cointegration vector. On the other hand, Gregory-Hansen test for cointegration analysis supports the existence of one cointegration vector. Gregory and Hansen tests propose three structural breaks for the money demand function. These structural breaks occurred in 2008:Q3, 2009:Q1 and 2010:Q1. Furthermore, through the error correction model and CUSUM and CUSUMSQ tests, the stability of the money demand function is examined. The results show that in the case of Greece, money demand is unstable during the period under investigation (2001:Q1-2010:Q4). (ProQuest: ... denotes formulae omitted.) Introduction The demand for money Md refers to the quantity of money that someone holds on average during a time period in order to finance his transactions. We assume that as long as real GDP (Y) increases, demand for money also increases, since real GDP measures the volume of goods and services circulated in the economy for a given time period. We also assume that as price level (P) increases, the real money demand for transactions increases, so that the demand for money in real terms remains the same. This is the so-called 'absence of money illusion' hypothesis. Our final assumption is that the demand for money is negatively related to nominal interest rate (r), which alternative savings like government bonds pay. More specifically, the higher the nominal interest rate, the higher the opportunity cost of holding money and hence the smaller the demand for money. Since the late 1980s, demand for money in industrial economies was in general unstable due to market freedom. That led central banks of these industrial economies to seize bank interest rates as the main mechanism of their monetary policy. Such an inappropriate choice of monetary policy could easily lead to growing instability. On the contrary, there is no evidence that demand for money in developing countries is not stable (Oskooee and Rehman, 2005). Nevertheless, in many developing countries, central banks switched to bank interest rates as a mechanism for their monetary policy. Hence, it is of great importance in research to apply contemporary techniques of developing time series in order to capture and test the stability of demand for money. So far, numerous empirical findings have estimated the demand for money in many countries and have also tested its stability. Demand for money, and in particular its seasonality, has great consequences in choosing the mechanisms of monetary policy. Poole (1970) showed that when LM curve is not stable, then central banks should use bank interest rate as means of monetary policy. When IS curve is not stable, then the most appropriate mechanism of monetary politics is the supply for money. Since a huge degree of instability of LM curve is due to instability in demand for money, it is of great importance to understand the degree of stability in the demand for money. The current paper aims at presenting an empirical work on the stability of the demand for money in the case of developing countries, such as Greece, taking into consideration the structural changes in the cointegration relationships by applying Gregory and Hansen (1996a) techniques. To achieve this aim, the paper is organized as follows: it reviews some previous empirical studies on demand for money in Greece, followed by the presentation of the model specification and econometric methodology used in the study. Subsequently, it discusses the empirical results, and finally, the conclusion is offered. …