Research Discussion Paper – RDP 8703 Money Demand, Own Interest Rates and Deregulation


This paper reports estimation and testing of general lag formulations of demand for M1, M3 and broad money (BM) using new data for the own rates of return on money. Own rate effects have become more important in the recently-deregulated financial environment. Own interest rates are found to be very important in explaining all three aggregates, although it is found that there is no contemporaneous interest rate effect on BM. BM appears to have the most stable econometric relationship with income and interest rates of the three aggregates, with M3 remaining unstable despite the introduction of own rates to the equation.

Own rate effects may enhance the efficiency of achieving low-inflation objectives by controlling money supply growth. Excessive interest sensitivity is reduced by the presence of own rates, as is the possibility of real interest rate overkill.

While the BM equation is found to have desirable properties, the econometric results are preliminary. The results certainly do not support BM as a target variable, since the lag structure is complex with respect to interest rates. Targeting BM would amount to little more than targeting nominal income directly, which requires knowledge of a wide range of influences on GDP.

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