Theoretical compliance of money demand function of Sri Lanka

This paper derives the monetarist version of broad money demand function for Sri Lankan economy using the quarterly data for the period from 1988: Q1 to 2012: Q4. This study employs both Johansen and Juselius (1990) multivariate method and Granger’s (1987) two-step method for cointegration to obtain structural values of the long-run money demand function: The stability of the model is tested using recursive coefficients and cumulative sum of squared residuals (CUSUM) tests. Results obtained from both co-integration testes suggest that the income elasticity of broad money demand is equal to one. Hence, it would provide an important guidance for the monetary authorities to regulate money supply as the intermediate target in order to achieve the final goal/goals of economic and price stability via the monetary transmission mechanism. This study concludes that growth of money over and above the real GDP growth will result inflation. The structural estimate received for inflation is higher than that of the real Treasury bill rate. Both the estimates are in theoretically expected signs and are also statistically significant. It means that public in Sri Lanka tend to substitute money for more real assets than the alternative financial assets during the time of higher inflation. Our tests on the stability of the broad money demand function confirmed that it is stable over time.