Stability of Money Demand in an Emerging Market Economy: An Error Correction and ARDL Model for Indonesia

Abstract

Predicting a stable money demand function is one of the key elements of monetary policy since monetary aggregates has theoretically important influences on output, interest rate and ultimate price level. By employing the vector error correction model (VECM) and autoregressive distributed lag (ARDL) approach, this paper investigates the M2 money demand for Indonesia in the period of 1990:1-2008:3. The results indicate that the demand for real M2 money aggregate is cointegrated with real income and interest rate. The real income has positive relationship with real money demand, both in the long-run and short-run. On the other hand, interest rate has a negative influence on M2 in the short-run, but has no statistically significant relationship in the long-run. Furthermore, we find that the ARDL model is more appropriate in predicting stable money demand function of Indonesia in compare to VECM.