Cointegration, real exchange rate and modelling the demand for broad money in Japan

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<ul><li><p>This article was downloaded by: [University of Chicago Library]On: 16 November 2014, At: 14:24Publisher: RoutledgeInforma Ltd Registered in England and Wales Registered Number: 1072954 Registered office: MortimerHouse, 37-41 Mortimer Street, London W1T 3JH, UK</p><p>Applied EconomicsPublication details, including instructions for authors and subscription information:</p><p>Cointegration, real exchange rate and modelling thedemand for broad money in JapanAugustine C. Arize a &amp; Steven S. Shwiff aa College of Business and Technology, East Texas State University , Commerce, TX,75429, USAPublished online: 28 Jul 2006.</p><p>To cite this article: Augustine C. Arize &amp; Steven S. Shwiff (1993) Cointegration, real exchange rate and modelling thedemand for broad money in Japan, Applied Economics, 25:6, 717-726, DOI: 10.1080/00036849300000124</p><p>To link to this article:</p><p>PLEASE SCROLL DOWN FOR ARTICLE</p><p>Taylor &amp; Francis makes every effort to ensure the accuracy of all the information (the Content) containedin the publications on our platform. However, Taylor &amp; Francis, our agents, and our licensors make norepresentations or warranties whatsoever as to the accuracy, completeness, or suitability for any purpose ofthe Content. Any opinions and views expressed in this publication are the opinions and views of the authors,and are not the views of or endorsed by Taylor &amp; Francis. The accuracy of the Content should not be reliedupon and should be independently verified with primary sources of information. Taylor and Francis shallnot be liable for any losses, actions, claims, proceedings, demands, costs, expenses, damages, and otherliabilities whatsoever or howsoever caused arising directly or indirectly in connection with, in relation to orarising out of the use of the Content.</p><p>This article may be used for research, teaching, and private study purposes. Any substantial or systematicreproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or distribution in anyform to anyone is expressly forbidden. Terms &amp; Conditions of access and use can be found at</p><p></p></li><li><p>Applied Economics, 1993, 25, 717-726 </p><p>Cointegration, real exchange rate and modelling the demand for broad money in Japan </p><p>A U G U S T I N E C . ARIZE and STEVEN S. S H W I F F </p><p>College of Business and Technology, East Texas State University, Commerce, T X 75429, U S A </p><p>The literature on the demand for the Japan's broad money addresses two controversial issues: the form (log level or log difference) in which variables enter the money demand function and the question of whether financial innovation and deregulation caused shift(s) in the money demand relationship. Log-level specifications of the money demand function have been shown to exhibit large shifts, whereas log-first-differences and error-correction specifications do not. Our paper demonstrates that the appropri- ate specification for the Japanese money demand function is that which uses cointegration and error-correction procedures. </p><p>I . I N T R O D U C T I O N </p><p>The literature on the demand for Japan's broad money [M2 plus certificate of deposits (CDs)] has grown immensely over the last two decades. This literature addresses two inter- esting and controversial issues: the form (log level or log difference) in which variables enter the money demand function and the question of whether financial innovation and deregulation caused shift(s) in the money demand relationship. Because a majority of these studies are not available in English, Yoshida and Rasche (1990, p. 10) have provided a summary of the empirical findings, whereas Corker (1990, p. 419) has reviewed the trends in broad money over the 1970-88 period. See also Arize (1990a) for the effects of financial innovations on Japan's money de- mand function. </p><p>Yoshida and Rasche report that a majority of these studies use a log-level Goldfeld (1973) type model. One of the findings from these studies is that the demand for broad money shifted between 1973-74. Whereas this shift was influenced by structural changes in the financial system and by financial innovation, there is no evidence that further shifts have occurred in the post-1974 period.' </p><p>Much of Hendry's work (for example, Hendry, 1980,1985) has been devoted to showing that parameter instability </p><p>claimed to prevail in the US and British money demand functions is a spurious phenomenon due to incorrect speci- fication. Work by Granger and Newbold (1974) has shown that the log level of many economic variables are non- stationary and, thus, subject to the 'spurious regression phenomenon.' Moreover, Phillips (1986) has shown that the use of a log-level model generates spurious inferences, because the usual t- and F-ratio test statistics do not have even the limiting distribution. These specification issues raise questions about the observed instability in the Gold- feld (1973) type models of Japan's broad-money demand function. </p><p>Quite recently, the appropriateness of the log-level speci- fication has been questioned by Ito (1989). His findings suggest that the log-level money demand model exhibits a large shift, whereas a log-first-difference shows little signs of instability. Ueda (1988), using the 'error-correction' model (ECM) advocated by Hendry and others, found no evidence of a shift in Japan's broad-money demand relationship. Corker's (1990) findings, using ECM, corroborate those of Ueda (1988), who found parameter stability over the quar- terly period, 1970-88. </p><p>The ECM appears to have four desirable features. First, it avoids the possibility of spurious correlation among strong- ly trended variables. Second, the long-run relationships that </p><p>'See Suzuki (1984) for more on this. </p><p>0003-6846 0 1993 Chapman &amp; Hall </p><p>Dow</p><p>nloa</p><p>ded </p><p>by [</p><p>Uni</p><p>vers</p><p>ity o</p><p>f C</p><p>hica</p><p>go L</p><p>ibra</p><p>ry] </p><p>at 1</p><p>4:24</p><p> 16 </p><p>Nov</p><p>embe</p><p>r 20</p><p>14 </p></li><li><p>A. C. Arize and S . S . Shwifl </p><p>may be lost by expressing the data in differences to achieve stationarity are captured by including the lagged levels of the variables on the right-hand side. Third, the specification attempts to distinguish between short-run (first-differences) and long-run (lagged-levels) effects. Finally, it provides a more general lag structure, which does not impose too specific a shape on the model (Hendry, 1980). </p><p>Recent work in econometrics by Engle and Granger (1987) has shown that a full error-correction representation would exist if the variables in question were properly 'cointegrable.' Given the cointegrability condition, reliable, or consistent, values for the steady-state parameters can be obtained by estimating the static 'cointegration' relation- ship. While their results established the validity of the traditional ECM, Engle and Granger go on to suggest a two- step estimation procedure that allows explicit tests of the underlying assumption of cointegration. This procedure is well known and will not be discussed in this paper. However, it is worth mentioning that the procedure allows questions of the appropriate specification of the dynamic elements of the model to be handled independently of the specification of long-run parameters. Yoshida (1990) is the first study to apply this procedure in estimating the demand for broad money in Japan. Following Ueda's (1988) suggestion concer- ning the impacts of wealth and land prices, Yoshida (1990) includes stock price variability as a regressor, in addition to real income and the coupon of five-year bank debentures in his cointegrating regression for the sample period 1968:Ql-1989:Ql. His findings suggest that the relationship between real broad-money balances and its determinants have remained stable. </p><p>However, in a more recent study, Yoshida and Rasche (1990) suggest that a shift in broad-money demand relation- ship occurred in 198542. This outcome conflicts with Corker (1 990). </p><p>The present study provides empirical support for the presence of a stable money demand function in Japan. Previous studies are extended in at least six respects. First, data for the floating exchange rate period, 1973:Ql-1988:Q4, are utilized. A characteristic of these previous studies is that the money demand equations are estimated with pooled data of both fixed and flexible exchange rate periods without justification for the equations being symmetrical during the periods. Second, the influence of international monetary influences on domestic money holdings in open economies is considered by including real exchange rate as another determinant of the demand for money. See, for example, Bahmani-Oskooee and Pourhey- darian (1990), whose work supports Arango and Nadiri (1981). Third, an ECM is estimated by application of the two-step estimator of cointegrated systems as developed in Engle and Granger (1987). Fourth, by considering both restricted and unrestricted ECMs, we distinguish between short- and long-run real exchange rates effects. Finally, particular attention is given to testing for higher-order </p><p>autocorrelation, functional form misspecification, simultan- eous equation bias, heteroskedasticity, and non-normal residuals. </p><p>It is important to mention that previous studies do not examine extensively the validity of their econometric model. For example, Corker (1990) overlooked his maintained hypothesis of cointegration and, consequently, interprets his empirical results mistakenly as evidence that the regressions determine long-run equilibrium money demand. As shown below, there is no evidence of cointegration between real broad money and the regressors in his model. Furthermore, Corker uses the instrumental variable (IV) procedure due to the presence of contemporaneous log-first-difference vari- able (interest rate spread). However, it is not clear whether the instruments used are statistically valid since a Sargan (1958) test is not applied. Similar comments can be made about the study by Yoshida (1990). </p><p>Finally, previous studies (see, for example, Corker, 1990) pay only lip-service to the issue of parameter stability without examining it in detail. These studies rely on the Chow (1960) test, but fcrget that the null hypothesis of parameter stability between split samples is conditional on the residuals being homoskedastic for the whole sample. Thus, the correct sequence is to test the uniformity of residuals across both samples before calculating the Chow statistic (see Arize, 1990a for more on this). Moreover, the reliance of previous studies on only a Chow test is perhaps unjustified, especially in the presence of a multitude of alternative tests. </p><p>The remainder of this paper is set out as follows. Section I1 describes the model. The estimation is carried out on quarterly data, over the period 1973-88. Section 111 repre- sents and discusses the empirical results of our preferred equation. The main conclusions are summarized in Section IV. Data definitions and sources are cited in the Appendix. </p><p>11. M O D E L S P E C I F I C A T I O N </p><p>The error-correction money demand has two parts. The first is a long-run equilibrium money demand that may be written as follows: </p><p>where m is the desired real M2 balance, Y is real income (Gross National Product), R is opportunity cost of holding money, Wis real wealth, K is real exchange rate, and e is the error term. It is expected that f l , &gt; 0, f12 &lt; 0, b, &gt; 0, and f14 &gt;O. The inclusion of real income and interest rate variab- les in the empirical broad-money demand function is stand- ard and needs little elaboration here. Corker (1990) has postulated that the broad money in Japan is held to finance transaction and as a store of value. As a result, a wealth measure to capture portfolio decisions among financial </p><p>Dow</p><p>nloa</p><p>ded </p><p>by [</p><p>Uni</p><p>vers</p><p>ity o</p><p>f C</p><p>hica</p><p>go L</p><p>ibra</p><p>ry] </p><p>at 1</p><p>4:24</p><p> 16 </p><p>Nov</p><p>embe</p><p>r 20</p><p>14 </p></li><li><p>Demand for broad money in Japan </p><p>assets and real gross national product (GNP) have been included in Equation 1. The deflator used is GNP (1980 = 100). Furthermore, Equation 1 takes into account the fact that a large portion of broad money is interest bearing. Therefore, the opportunity-cost variable was proxied by the three-month average Gensaki rate minus the average return on holding broad money. Note that the Gensaki rate is market determined, whereas the call rate used in Yoshida and Rasche (1990) is largely regulated. </p><p>To account for the effects of international monetary developments on the demand for broad money, real ex- change rate is also included in our specification. Recently, several analysts, such as Bahmani-Oskooee (1991), and Arango and Nadiri (1981) found some success with a proxy for international monetary influences on domestic money holdings in their money demand functions. Furthermore, as will be shown below, the null hypothesis of non-cointegr- ation is rejected only when the real exchange rate variable is included with some variables that appear in the long-run model of Corker (1990), that is, real GNP, real wealth and net interest rate. </p><p>The estimation of Equation 1 raises several econometric issues. First, the time-series properties of the data should be investigated. For instance, are the variables stationary in levels or in first differences? Estimation of Equation 1 using non-stationary data will lead to unreliable t-statistics, as the underlying time series would have theoretically infinite variances. Even if each individual time series is level-non- stationary, is the linear combination of these series as suggested by Equation 1 level-stationary? Second, the dy- namic adjustment of the demand for money is neglected. Notably, are its determinants instantaneous? If not, how should the dynamic adjustment be modelled? </p><p>The present discussion leads to the second part of Equa- tion l . Collective wisdom, based mainly on intuition, sugges- ts that actual money balances do not always equal what the public wishes to hold on the basis of long-run factors specified in Equation 1. Therefore, the second part of the model is a dynamic error-correction equation of the form </p><p>where all variables are as defined above. Note that other variables such as AlnP, may be included in the equation, where P is GNP deflator. Further, E is the short-run random disturbance term. A refers to the first-difference operator; C j (j = 1-5) represents the number of lags, and el - , is the lagged value of the long-run random disturbance term. Equation 2 </p><p>gives the short-run determinants of broad money, which include, among others, current and past changes in the scale; opportunity cost and exchange rate variables; and the lagged value of the residual from the long-run money- demand function, that is, Equation 1. The parameter I t...</p></li></ul>


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