Sector GDP concentration bias in the Macro-Money demand specification: New evidence for India

Abstract

Money serves as an intermediate target variable for transmitting monetary policy actions in macroeconomic management. In this connection, no other macro-behavioral function is subjected to more modelling modifications and regression rigors than the macro-money demand function. Monetary policy planning crucially depends on the parameters of the money demand function. An emerging market economy undergoes structural change in the sector GDP composition when compared to that of a structurally (invariant) mature advanced economy. This obviously introduces a bias in the estimation of the income elasticity of money demand parameter if the structural change were not modelled into the money demand function. The present study tries to incorporate this structural change into the money demand function as an additional variable besides the aggregate GDP and interest rate as the conventional scale and opportunity cost parameters variables respectively. The simplified algebra permits us to proxy the sector GDP concentration variable by the numbers equivalent Herfindahl index(H) For the opportunity cost variable,1-3 year deposit rate and the call money rate are alternatively used. Maximum Likelihood estimates of the have thrown up a statistically highly significant positive coefficient of the H variable besides equally highly significant scale and opportunity cost variables with their expected positive and negative coefficients respectively. This empirical evidence suggests that without this variable, the conventional specification of the money demand function contains a serious policy-centric specification error. Also, the implication of the result is that as the sector GDP concentration increases, the demand for real money balances increases less proportionately, indicating presence of economies of scale.