Is the demand for money stable in the face of rapid monetisation? Evidence from Ethiopia

Purpose The purpose of this study is to investigate the stability of the money demand function in the face of the rapid monetisation of the economy in Ethiopia. Design/methodology/approach This study covers the period 2001/02q4-2022/23q4. A traditional money demand function is estimated, using total gross domestic product (GDP) as a scale variable and inflation expectation as the opportunity cost of money, applying a bounds testing approach to cointegration. As the result shows that the variables are not cointegrated, a variable proxying monetisation is incorporated, and the money demand function is re-estimated. An error-correction model within the auto-regressive distributed lag (ARDL) framework is used to examine the short-run money demand dynamics. CUSUM and CUSUMSQ tests are also applied to examine the stability of money demand. Findings This study finds that the traditional money demand function, which uses GDP as a budget constraint and inflation expectations as opportunity cost, is unstable. The inclusion of monetisation in the money demand equation not only makes the equation stable but also provides a result consistent with the theoretical expectations. This result is also supported by CUSUM and CUSUMSQ tests. Research limitations/implications This study has used quarterly GDP data, interpolated from the annual GDP data using the Denton method due to the unavailability of quarterly GDP data. The use of a different method of interpolation may provide a different result. The other issue is the measure of monetisation. Although there are several methods of measuring monetisation, this study used the currency-to-total money ratio. Future studies can use an alternative measure of the monetisation in the money demand function. Practical implications This study contributes to the literature in two ways. At the policy level, this study provides inputs for the monetary policy framework that the National Bank of Ethiopia (NBE) is introducing. Since the study finds evidence that monetisation is a relevant variable in the money demand function, the NBE should consider the monetisation process in its monetary programming. A stable money demand function implies that the demand for money is reasonably predictable. This enables the NBE to reliably forecast the money supply consistent with the target level of inflation, concentrate on other monetary management functions and reap the benefits of money demand stability arising from the inclusion of monetisation in the money demand. At the theoretical level, this study tests the stability of demand for money, which is one of the major pillars of the theory of money, in the context of the rapid monetisation of the Ethiopian economy. Originality/value Empirical studies on the stability of money demand in developing countries use GDP as a scale variable and a variable(s) for the opportunity cost of money despite the economies undergoing rapid monetisation. This may result in misspecification of the money demand function. The originality of this study lies in including monetisation in studying the stability of money demand in Ethiopia, a country that experienced rapid monetisation for longer than a decade.