Exchange rate changes and money demand in Albania: a nonlinear ARDL analysis
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Exchange rate changes and money demand in Albania: a nonlinear ARDL analysis Mohsen Bahmani‑Oskooee1 · Ilir Miteza2 · Altin Tanku3 Received: 13 June 2019 / Accepted: 23 December 2019 © Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract A good part of the empirical literature on money demand focuses on searching for a stable long-run money demand function, an essential part of a successful monetary policy. Beyond the typical money demand specification, which includes income and interest rates, Mundell (Can J Econ Polit Sci 29:475–485, 1963) made a case for the exchange rate as an important determinant of money demand working through currency substitution. This paper contributes a new approach to test the short- and long-run effects of currency fluctuations on money demand in Albania, a small open economy without deep financial markets. More specifically, we examine the case for asymmetric effects of exchange rate fluctuations on money demand by using a nonlinear adjustment mechanism within an ARDL model. Using data for 1996–2016 from Albania, we show that the money demand is stable in both the linear and nonlinear specifications. The nonlinear model reveals an asymmetric effect of exchange rates on money demand, with depreciations reducing money demand, likely due to a substitution effect amplified by a relatively dollarized economy. Keywords Money demand · Exchange rate · Currency substitution · Nonlinear ARDL · Asymmetric effects JEL Classification E41 · F31
* Mohsen Bahmani‑Oskooee [email protected] Ilir Miteza [email protected] Altin Tanku [email protected] 1
University of Wisconsin – Milwaukee, Milwaukee, USA
2
University of Michigan – Dearborn, Dearborn, USA
3
Bank of Albania, Tirana, Albania
13
Vol.:(0123456789)
Economic Change and Restructuring
1 Introduction Conducting an effective monetary policy requires a stable money demand relation in order for money supply changes to have a predictable effect on central bank targeted variables. Empirical investigation and debates over money demand stability have continued well after Friedman and Schwartz (1991) who made the case for a stable long-run money demand equation. Because targeting a particular interest rate has been the norm for most central banks in industrialized economies, an impression may have been formed that the stability of money demand is irrelevant. The European Central Bank’s two-pillar approach corroborates the importance of a long-run relationship between monetary aggregates and prices. Lack of money demand stability would move other central banks in the same direction, weakening the case for using interest rate instruments in monetary policy. In a similar fashion with the dual-pillar approach of the European Central Bank, monetary policy in Albania, in its communication with the public, emphasizes an inflation target and inflation expectations tightly anchored around this target (Shijaku 2016). At the same time, Bank of Albania monitors an intermediate objective for money growth based on evidence of
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