Inflation Expectations and the Demand for Money in Iceland

Inflation and the demand for money in Iceland are reported on in this paper. Various specifications of the money demand relationship are estimated for the period 1952-1979. The estimates indicate that the income elasticity of money demand (M3) is in the neighborhood of 0.5. Measured income rather than permanent income appears to be the appropriate scale variable. The opportunity cost of holding money, represented by expected inflation, has a significant negative impact on the demand for real money balances. I. Introduction For two decades, economists have undertaken to estimate the parameters and test the stability of various formulations of demand for money equations in a large number of empirical studies. The existence of stable demand for money functions has been ascertained for a number of countries, revealing broad similarity in parameter estimates. ' Yet, with a few notable exceptions, the research has been limited to highly industrialized economies in the post-World War II period.2 The empirical support for the modern theory of money demand in Iceland is examined in this paper. Evidence for a stable demand for money function in this micro economy, which contains a rare blend of highly developed and underdeveloped institutions, should elucidate the general validity of current monetary theory. With a population of about a quarter million (229000), the country's financial and money markets are at the embryonic stage. Interest rates are pegged, international capital movements strictly regulated, and the Central Bank does not engage in open market operations. There is heavy dependence on foreign trade, and due to its primary reliance