Abstract:
By employing the statistical tools of the cointegration analysis and the adjustment matrices, and the Vector Error Correction models, it is established that there is a statistically significant long-run demand function for real narrow money in India (LRM1). There is cointegration, and there exists long-run demand for money functions for both the narrow money (LRM1), and for the broad money (LRM3). In narrow money demand function (LRM1), the sign of the coefficient of the real stock prices is positive and statistically significant corroborating the wealth effect. The wealth effect may be because as the real stock prices increase, the wealth to income ratio and the volatility of the return of assets, increases and the demand for the least volatile return asset- the narrow money (M1)- increases. Similarly, for the real broad money demand function (LRM3), the statistical tests results corroborate existence of a long-run demand for broad money. But, unlike the demand for narrow money (M1), for broad money (M3), the real stock prices have negative sign and statistically significant in the cointegrating vector, indicating a substitution effect of reducing the demand for broad money, when real stock prices increase. This is obviously as M1 is medium of exchange proper, the least volatile return yielding asset, and M3 consists mostly the store of wealth, the volatility of return is higher than that of the narrow money. The short-term interest rate is statistically significant with negative sign only for the narrow demand for money function (LRM1). This also means that the interest rate as an opportunity cost variable is empirically applicable only for the narrow money (M1). This is also because a part of the broad money(M3) yields interest return and therefore, board money (M3) holding does not involve much an opportunity cost unlike narrow money (M1). Apart from the capital and money markets, and the real GDP, the foreign exchange markets also have a role in determining the real money demand. The foreign exchange value of domestic currency in crease, increases the demand for broad money (LRM3). Therefore, as there is a stable long-run demand function for money in India, the money has not withered away, despite financial innovations, and the monetary aggregates should be again recognized as important monetary policy indicator variables in India and other countries. In the recent monetary policy in India, as in other countries with inflation targeting monetary policies, the monetary aggregates seem to have been neglected, even as an indicator variable; but our results point out that it is not a correct policy. Our contribution to the discussion in the theory of the monetary policy rules is that the money cannot be totally ignored in the monetary policy rules and practices, as the real balance effect of spending is strong in influencing the prices and the real output, which our econometric estimation of real money demand functions corroborates.

Keywords:
Money Supply and Demand for Money, Monetary policy and inflation targeting, Capital Markets, Cointegration and Error Correction models.

JEL Classifications: E3, E4, E5, C1.