Monetary Policy and Demand for Real Cash Balances: Some Theoretical and Empirical Results
Abstract
Influence of monetary policy is ordinarily studied within Hicksian model. This, nonetheless, tolerates only the comparison of positions of static equilibrium making model inapt to analyse the path of an economy that is out of equilibrium. In a complex, dynamic economy experiencing incessant structural transformation with technical and institutional rigidities, inertia and contractual obligations, autoregressive model of adjustment mechanism must apply. This paper revealed that it might be disingenuous and cynical to view the real world using Hicksian static formulation particularly in the short run. The objective of this paper was to examine impact of monetary policy on demand for real cash balances by establishing how dynamic considerations could enter monetary economics. This paper ingeniously introduced adjustment-lagged variable in the conventional money demand function and estimated elasticity coefficient of adjustment. Regression analysis on the monetary data from 2000-2022 was conducted. The study found that money demand in Kenya responds diminutively to changes in interest rate. Estimated elasticity coefficients of adjustment revealed that in aggregate, Kenyans adjust their portfolio within a year. If central bank changes money stock, this study established that the smaller the value of interest elasticity coefficient, the greater the necessary change in rate of interest needed to accommodate such a policy. These elegant results set limits to the extent in which the volume of money in circulation could be raised in an exogenous manner at the behest of monetary policy committee. The study concluded that the less the demand for real balances vary with interest rates, the greater will be the efficacy of monetary policy. Thus, effectiveness of monetary policy is directly correlated with low interest elasticity of money demand. Violent rise in interest rate might precipitate a failure of the banking system
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