An analysis of demand for money in Uganda (1986 - 2003)

Abstract

A stable money demand function is the essence of planning and implementing monetary policy. The main purpose of this paper is to Estimate Uganda's money demand function and to find out whether there exists a stable money demand function in Uganda. This study presents both a descriptive and empirical analysis of money demand in Uganda over the period 1986:1-2003:4. It also reviews some basic concepts of money demand theory, summarizes the results of developed and developing countries' studies that have used partial adjustment model (PAM), Co-integration and/or error correction techniques and reviews model specification issues. The study makes use of an expanded model incorporating institutional variables in addition to the normally used (traditional) variables. Two definitions of money (M1/P and M2/P) were used and they exhibited a general upward trend for the most of the period under study. In addition, the study tests for the existence of co-integration between monetary aggregates and real money balances. Following the existence of co-integration, error-correction models were built for the two money demand functions namely real Narrow Money (M1/P) and real Broad money (M2/P) demand. From our results, income (GDP) in the two Money demand functions was found to be positively related to money demand and not significantly different from unity which implied that for the period, increases in income led to an increase in real cash balance. Money demand was also found to be negatively related to exchange rate and interest rate in the two functions, suggesting that there is a degree of substitution from non-interest bearing Ugandan notes into interest bearing financial assets and into holdings of foreign currency. Also inflation was found to be negatively related to the money demand functions. Financial innovation was found to have a negative effect on M1/P and M2/P. The Money demand functions remained stable for the entire period, as confirmed by the chow tests, forecast statistics and the recursive graphics. The empirical findings conclude that the demand for money in Uganda is stable.