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EuroJournals Publishing, Inc. 2009

http://www.eurojournals.com/finance.htm

ASEAN-5

Han Yu

Finance School, Guizhou College of Finance and Economics

Guiyang, P. R. China

E-mail: derec_2001@yahoo.com.cn

Pei-Tha Gan

Department of Economics, Faculty of Business and Economics

Universiti Pendidikan Sultan Idris, Tanjong Malim, Malaysia

E-mail: gan.pt@fpe.upsi.edu.my

Abstract

This paper investigates the dynamic of relationship between real money balances

and real income, lending rates, interest rates and inflation rate in ASEAN-5, namely

Indonesia, Malaysia, Philippine, Singapore and Thailand. Using sample period for each

country spans from 1987 month one through 2007 month four, the empirical results

indicate that (1) cointegration technique two step Engle Granger (1987) and error

correction model (ECM) clearly show that there exists a long run relationships between real

money balances and its determinants and (2) the ECM analysis has provided a support to

the short-run relationships between M2 and real income, lending rates, interest rates and

inflation rate for ASEAN-5.

Keywords: Engle-Granger cointegration test, Error correction model, M1, M2

JEL Classification Codes: E31, E41, E51

1. Introduction

The objective of this paper is to empirically investigate whether an equilibrium relationship exists

between certain combinations of money balances, a scale variable, an opportunity cost measure and

cost of credit. The present study attempt to determine factors affect the demand for money in some

ASEAN countries. The paper examines the role of interest rates and expected rate of inflation in the

money demand function as the appropriate measure of opportunities cost of holding money. The paper

investigates the significance of the costs of credit variable in the demand for money function. In

developed countries, the implementations of monetary policy changes were used to alter the short run

business cycle fluctuations, although long run price movement was likewise, the more important

objective. In developing countries, however, long run economic growth were highly emphasized in

the monetary policy, where money expansion is frequently used as a major source of governments

demand management. Public demand for newly created money, in turn has implication on critical

macroeconomic variables such as income, interest rates, expected inflation and exchange rates. As a

consequence, money demand plays a central role in the success or failure of the development of a

country.

169

Theoretically, the demand for real money balances could be divided into transactions demand

component, which is positively related to the income and inversely related to interest rates,

precautionary demand component, positively related to income and speculative demand component,

inversely related to interest rates. In addition, the paper includes the cost of credit as a determinant of

demand for money. Following the previous studies and real world experience, the cost of credit does

matter in developing countries. Since, in developing countries the transaction using broad money (M2)

very often takes place. The government, the business and investors are using credit or lending to ensure

the smooth running of their development activities. The banking system and other financial institutions

create money by giving loans. However, it is a practice that during economic boom and the returns on

investment is high and it encourages an increase in borrowing and lending activities with a relatively

lower cost of credit. By contrast, during economic crisis either it is inflation or deflation, the banks and

other financial institutions increase the cost of borrowing in order to discourage the clients from

borrowing. So an increase in the cost of borrowing is likely to decrease the demand form money.

In this study, cointegration technique developed by Engle-Granger (1987) is being used to

estimate a money demand function in a number of ASEAN developing countries, namely: Indonesia,

Malaysia, Philippine, Singapore and Thailand.

2. Literature Review

Generally, empirical studies regarding money-demand relationship in developing economies generally

use a long-level Goldfeld type model (see Goldfeld, 1973), that relates desired real money balances to

a scale measure, such as the real income and returns of one or more alternative assets to measure the

opportunity cost of holding money. Most studies include a lagged dependent variable term to

approximate the short-run dynamic adjustments. However, as suggested by Arango and Nadiri (1981),

the portfolio decision should include, at least, domestic real assets, domestic financial assets and

foreign financial assets. The omission of the opportunity cost variable of some assets may result in a

misspecified money demand function.

Hossain (1988) estimated a short-run money demand model for Bangladesh using quarterly

data from 1974:1 to 1985:4. The author found a Laidler (1982) short-run real money demand model,

which is appropriate for Bangladesh on the basis of the set of criteria suggested by McAleer et al.

(1985). On the basis of MacKinnon et al. (1983) non-nested test of model selection, the author

concluded that neither the log-linear nor the linear functional form has any advantage over the other for

Bangladesh. The author found the real permanent income and expected inflation rate are the significant

explanatory variables in the demand for money function. The real permanent income was measured as

four quarters unweighted moving average of actual real income and expected inflation was measured

as one-period lagged inflation rate. Finally he found that both narrow money (M1) and broad money

(M2) functions were empirically stable.

Azali and Matthews (1999) proved, among the others, the money as well as credit innovations

made significant contribution to the output fluctuation. Hence there is a growing consensus explaining

money view is not the only way of understanding the transmission mechanism of monetary policy.

Nevertheless, proponents of credit view for example Iturriaga (2000), pointed out that credit view does

not rule out the conventional money view, but rather offers new explanations based on capital market

imperfections. In fact, Schreft and Smith (2000) demonstrated that financial innovations pose no threat

to the traditional methods employed in conducting monetary policy. He provided the evidence of the

credit channel as a possible way of transmitting monetary policy decision. Bacchetta and Ballabriga

(2000), mentioned, among the others, the bank loans magnify the impact of monetary policy.

Recently, Bahmani-Oskooee and Rehman (2005) analyzed the money demand functions for

India and six other Asian countries during the period beginning with the first quarter of 1972 and

ending with the fourth quarter of 2000. Using the ARDL approach descried in Pesaran et al. (2001),

they performed cointegration tests on real money supplies, industrial production, inflation rate, and

exchange rates (in terms of US dollar). For India, cointegration relationships were detected when

170

money supply was as M1, but not M2, so they concluded that M1 is the appropriate money supply

definition to use in setting monetary policy.

The general agreement in the literature is that a money demand function should contain a scale variable

relating to the level of transactions in the economy and a variable representing the opportunity cost of

holding money. However, Wong (1977) argued that there may be some rationale for inclusion of

interest rates in the demand for money in developing countries as there exists certain links between

formal and informal credit markets, and borrowing is still a means of financing economic activities.

The degree of credit constraint, which may reflect the unobservable interest rates in the money demand

function. In view of this argument, the following money demand function that incorporates three

explanatory variables for estimation purpose is specified as follows:

Mt = a + b t + c GDPt + d Rt + e LRt + t

(1)

Note:

a is constant

b to e are coefficient for each variable

Economic rationale suggests that c>0 while b<0, d<0, e<0, and <0.

where,

Mt

= log of real money demand (M1 or M2) at time t;

GDPt = log of real income GDP at time t;

Rt

= interest rates at time t;

t

= expected rate of inflation at time t;

LRt

= lending rate as a proxy of cost of credit at time t;

t

= error term at time t;

M1

= narrow money defined as currency in circulation plus demand deposits;

M2

= broad money defined as M1 plus time and savings deposit at commercial banks.

M1 and M2:

The quarterly series of M1 and M2 are obtained from IFS.

Gross domestic product: The quarterly series of the nominal gross domestic product (NGDP) is

taken from IFS. The NGDP is divided by consumer price index (CPI) to

obtain the real terms of this variable GDP.

Money market rate:

The quarterly series of money market rate from the IFS is used as interest

rates.

Consumer price index: The quarterly series of CPI is taken from IFS. The inflation rate is taken

from the first difference of the log of CPI level.

Lending rate:

The quarterly series of lending rate is taken from the IFS.

Interpolation method is used on GDP variable. The purpose is to derive monthly figures from

quarterly data.1

Sources of data

Data source: all data are monthly for 1987-month 1 to 2007-month 4 period and taken from

International Financial Statistics of IMF, various issues.

The codes for interpolation (i.e. RATS procedure DISTRIB) are available at www.estima.com/Interpolation.shtml

171

4. Methodology

Test for order of integration

The unit root test is to determine whether each data series is non-stationary (that is unit root exist) or

stationary (unit root do not exist). The importance of test stems from the fact is that it forms the

preamble to the econometric analysis of long-run equilibrium relationships proposed by economic

theory. On economic grounds, the conceptual existence of equilibrium relationships proposed by

economic theory means that there exists the belief that certain economic variables should not wander

freely or be independent to each other, instead, they are expected to move so that, they do not drift too

far apart.

PhillipsPerron (PP) test for the stationary series is the modification from Dickey Fuller t

statistics. The test allows the error terms to be weakly dependent and heterogeneously distributed.

Testing for the presence of a unit root with Phillips Perron tests involves estimating the following

equation by OLS:

(2)

Yt = u* + a*1 Yt 1 + *t

Yt = + 1 Yt 1 + 2 (t T/2) + t

(3)

*

where t and t are error terms and T is the sample size. We are testing the null hypothesis. In each

case, the Ho that Yt has a unit root is tested against the alternative that Yt is stationary.

Z (t a*1):

test the hypothesis a*1 = 1

Z (t 1):

test the hypothesis 1 = 1

Z (t 2):

test the hypothesis 1 = 0

test the hypothesis 1 = 1, and 2 = 0

Z (3):

The two-step Engle-Granger cointegration test for long run

Suppose one determines that Y and X following the random walks, but Yt and Xt are stationary.

Then to test whether Yt and Xt are cointegrated, we simply runs the cointegrating regression as

following:

Yt = + X t + t

(4)

Then testing whether the residual, t from this regression are stationary. If they were not

cointegrated, any linear combination of them would be nonstationary. Specifically, we test the

hypothesis that t is not stationary, i.e. the hypothesis of no cointegration. A test of the hypothesis

implies that t is nonstationary and it can be done in using ADF test.

An augmented Dickey-Fuller test can be performed on the residual series. ADF requires

estimation of the following:

N

t = t 1 + b i t 1 + t

(5)

t =1

where and bi are the estimated parameters and t is the error term. If the t statistic of coefficient

exceeds the critical value, the t residuals from the cointegration regression are stationary; in addition,

the independent variable and dependent variable are cointegrated.

Error Correction Model (ECM)

If Yt and Xt are cointegrated, then there is a long-term equilibrium relationship between the two

variables. Of course in the short run, there may exist the disequilibrium. Therefore, the error term in

equation can be treated as the "equilibrium error". Fortunately, Engle and Granger (1987) provided a

remedy to correct the problem, suggesting that cointegrated series can be represented by an error

correction model (ECM) as:

Yt = 0 + M,i=1yiYt-i + N,i=1xiXjt-i + 3ut-1 + t

(6)

(Note: J in this study is inflation, real income, interest rates and lending rates)

172

where u t is the lagged value of error term from the cointegration equation:

Yt = Xt + u t

(7)

The estimates of error correction model, testing the hypothesis that past changes in independent

variables and error correction term will not cause a current changes in the dependent variables (i.e. that

the coefficient of lagged variables and the error correction term (residual) are jointly zero). If they are

significant, the lagged variables are important in predicting current movement of the dependent

variable, and the dependent variables in the equation adjusted to the previous equilibrium error. It is

noted that the specification of the number of lags (m) in this regression is randomly chosen. Generally,

it is suggested that the tests can be run for a few different values of (m) to make sure the result are not

sensitive to the choice of (m). With monthly data, it is recognized that lags up to 4 and to 12 months

are likely to be sufficient.

The Phillips Perron integration test is given in Table 1. The results show that all the variables are

non-stationary at level having unit roots. On the first difference of time series, all variables in five

selected countries are stationary; except for GDP in Thailand have unit roots, which it is not significant

at the first difference, but significant at second difference. Table 1 results present the findings that all

variables in the five selected countries are integrated in order one, except GDP in Thailand integrated

in order two.

Table 1:

Variable

173

Level

Intercept with trend

First difference

Intercept without trend

Malaysia

CPI

-3.626221 [4]

-10.66908 [4]*

R

-1.993611 [4]

-7.972623 [4]*

GDP

2.460084 [6]

-3.499366 [6]*

LR

-2.935993 [4]

-11.05665 [4]*

M2

-3.164899 [4]

-13.43523 [4]*

M1

0.003157 [4]

-11.91818 [4]*

Thailand

CPI

-2.548343 [4]

-9.712396 [4]*

R

-1.436003 [4]

-9.521124 [4]*

GDP

-3.644802 [6]

-0.896147 [6]

LR

-0.967722 [4]

-8.020581 [4]*

M2

-0.069044 [4]

-10.48523 [4]*

M1

-2.552771 [4]

-11.93708 [4]*

Singapore

CPI

-0.816641 [4]

-13.59854 [4]*

R

-1.414863 [4]

-10.42455 [4]*

GDP

-1.574264 [2]

-3.485910 [2]*

LR

-2.055591 [4]

-6.931661 [4]*

M2

-1.848404 [4]

-10.90287 [4]*

M1

-3.988124 [1]

-21.26106 [1]*

Philippines

CPI

-1.723841 [4]

-10.43978 [4]*

R

-2.482318 [4]

-11.77639 [4]*

GDP

-1.714985 [4]

-3.495254 [4]*

LR

-2.324024 [4]

-13.58733 [4]*

M2

-2.780896 [4]

-12.64132 [4]*

M1

-0.524988 [4]

-15.21597 [4]*

Indonesia

CPI

-0.429561 [4]

-4.917065 [4]*

R

-1.592332 [4]

-12.98891 [4]*

GDP

-1.927538 [4]

-5.086030 [4]*

LR

-1.009978 [4]

-9.765543 [4]*

M2

-2.097304 [4]

-19.05195 [4]*

M1

-3.283079 [4]

-15.76593 [4]*

Notes: In each case, the Ho that Yt has a unit root is tested against the alternative that Yt is stationary. Since these

statistics are asymptotically equivalent to the corresponding Dickey-Fuller tests, the critical values from Fuller

(1976) and Dickey (1981) can be used in testing. * Indicates evidence of rejection of unit root at 1% level. The

numbers of lags are in the bracket.

Next, cointegration tests are performed to test the presence of a long-term equilibrium

relationship among the variables. Engle Granger (EG) two-step had been used. The EG estimation are

similar to the one of unit root. We test the residuals obtained from each money demand function of five

selected countries, and use the ADF test.2 The results from implementing the Engle Granger

cointegration are presented in Table 2 and Table 3.

If the dependent variable and independent variables are not cointegrated, any linear combination of them will be

nonstationary and, therefore, the residuals u t will be nonstationary too.

174

Table 2:

Engle Granger Two-Step for M1

Coefficient on regressors

ADF auxiliary regressors

2

2

3

4

R

Lags

C

1

3

-3.28

-2.93

19.25

-0.11

-0.22

0.96

-3.7792*

4

Thailand

0.72

-0.01

0.99

-0.06

-0.51

0.98

-2.8384*

4

Indonesia

2.37

-4.76

2.75

-0.21

-0.37

0.98

-3.2889*

4

Malaysia

-0.63

-0.05

1.34

-0.12

-0.11

0.99

-5.7774*

4

Philippines

-0.31

-1.29

0.59

-0.04

-0.34

0.98

-4.9659*

3

Singapore

Notes: * Mackinnon critical values for rejection of hypothesis of a unit root at 5%. The numbers of lags are in the brackets.

Countries

Table 3:

Countries

Coefficient on regressors

2

2

3

4

R

Lags

C

1

-4.32

-3.83

16.35

-0.04

-0.02

0.98

-2.9115*

4

Thailand 4

-0.89

-0.24

1.36

-0.14

-0.38

0.97

-2.5164*

4

Indonesia

-3.59

-3.59

0.30

-0.21

-0.41

0.99

-2.8394*

4

Malaysia

-0.36

-1.23

2.62

-0.16

-0.04

0.99

-3.9690*

4

Philippines

-1.98

-1.38

0.91

-0.18

-0.69

0.96

-2.8364*

3

Singapore

Notes: * Mackinnon critical values for rejection of hypothesis of a unit root at 5%. The numbers of lags are in the brackets.

The test was conducted sequentially by further reducing lag. The procedure was repeated until

the restriction could be rejected at 5% and 10% level. Table 2 and Table 3 indicate that there are long

run relationships between M1 and its determinants; M2 and its determinants respectively for the

sample period covered in this study.

Table 2 and Table 3 just showed that M1 and M2 and its determinants are cointegrated. Of

course, in the short run there may be disequilibrium. Therefore, one can treat the error term in

(equation) as the equilibrium error. Error term can be used to tie the short run behavior of M2 to its

long run value. The error correction mechanism (ECM) was initially used by Sargan (1964) and latter

popularized by Engle and Granger corrects for disequilibrium.

3

4

For Thailand GDP is estimated in first difference.

Table 4:

175

Variables

Coefficient

t-ratio

Probability

Dependent variable: M1t

Malaysia

Constant

-0.004168*

-1.065916

0.2884

ECM t-1

-0.139893*

-3.076510

0.0019

M1 t-10

-0.237211*

-3.065039

0.0026

CPI t-3

-2.148390*

-2.262726

0.0253

GDP t-3

3.041240*

3.794380

0.0002

R t-4

-0.095993**

-1.902870

0.0593

LR t-1

-0.158648**

1.893853

0.0605

Thailand

Constant

0.006639*

3.835433

0.0002

ECM t-1

-0.263431*

-4.712762

0.0000

M1 t-3

0.188400*

2.342103

0.0208

CPI t-1

-2.050446*

-3.473282

0.0007

GDP t-15

4.130483**

1.617090

0.0932

R t-5

-0.094712*

2.054221

0.0421

LR t-6

-0.236025**

1.880685

0.0624

Singapore

Constant

-0.001189*

-0.352943

0.7247

ECM t-1

-0.570108*

-5.947454

0.0000

M1 t-1

-0.226557*

-2.829111

0.0054

CPI t-4

-2.052671**

-1.679362

0.0955

GDP t-9

1.422682**

1.837762

0.0684

R t-9

-0.573705*

2.194587

0.0300

LR t-9

-0.963097**

-1.819568

0.0711

Philippines

Constant

0.004002*

0.779530

0.0071

ECM t-1

-0.463200*

-6.695092

0.0000

M1 t-9

-0.202667*

-2.813637

0.0057

CPI t-7

-0.706163**

-1.747369

0.0829

GDP t-6

1.151471

1.015783

0.3116

R t-1

-0.078986*

2.121813

0.0358

LR t-10

-0.182408*

-3.953567

0.0001

Indonesia

Constant

0.006520*

3.401042

0.0009

ECM t-1

-0.164446*

-3.548723

0.0005

M1 t-3

0.140300**

1.758204

0.0810

CPI t-2

-0.761969*

-2.974491

0.0035

GDP t-4

0.279183

1.631612

0.1051

R t-5

-0.077451**

-1.729600

0.0860

LR t-5

-0.323062*

0.106654

0.0029

Notes: * and ** denote statistical significant at 5% and 10% level, respectively. is first difference. is second

difference. CPI is an inflation (t). ECMt-1 is one period lagged error correction term. Batteries of diagnostic tests

were applied for each equation. The ECM passed most of the diagnostic tests including serial correlation,

functional form and heteroscedasticity (The results are available on request).

176

Table 5:

Short-Term Dynamics Error Correction Model for M2

Variables

Coefficient

t-ratio

Probability

Dependent variable: M2t

Malaysia

Constant

0.008859 *

4.230087

0.0000

ECM t-1

-0.114411 *

-3.288963

0.0013

M2 t-2

0.185761 *

2.258886

0.0255

CPI t-5

-1.298427 *

-2.573674

0.0111

GDP t-3

-0.765278 **

-1.714923

0.0887

R t-1

0.056101 **

1.970451

0.0508

LR t-6

-0.073978 **

1.658513

0.0996

Thailand

Constant

0.005179 *

8.129764

0.0000

ECM t-1

-0.037292 **

-1.961460

0.0519

M2 t-3

0.219359 *

2.652009

0.0090

CPI t-6

-0.295117 **

-1.975338

0.0503

GDP t-8

-1.586034 *

-2.817538

0.0056

R t-5

0.022956 **

1.956470

0.0525

LR t-3

-0.053035 **

1.857360

0.0655

Singapore

Constant

0.010248 *

5.758511

0.0000

ECM t-1

-0.061698 *

-2.836667

0.0053

M2 t-3

0.140095 **

1.708556

0.0899

CPI t-8

-1.228011 *

-2.131463

0.0349

GDP t-10

-1.256676 *

-3.093406

0.0024

R t-11

0.150293 *

3.791080

0.0002

LR t-8

-0.243338 *

3.047593

0.0028

Philippines

Constant

0.005023

1.495613

0.1372

ECM t-1

-0.204272 *

-4.895408

0

M2 t-8

-0.135844 **

-1.846255

0.0671

CPI t-8

-0.915210 *

-3.560325

0.0005

GDP t-4

1.328482 **

1.871908

0.0634

R t-9

-0.042280 **

1.737582

0.0846

LR t-9

-0.061925 **

1.937716

0.0548

Indonesia

Constant

0.013398 *

6.812734

0.0000

ECM t-1

-0.081524 *

-2.991474

0.0033

M2 t-1

-0.350279 *

-4.951038

0.0000

CPI t-1

-0.927630 *

-3.937841

0.0001

GDP t-5

0.652772 *

4.109254

0.0001

R t-8

-0.138951 *

-3.528497

0.0006

LR t-5

-0.376195 *

4.051964

0.0001

Notes: * and ** denote statistical significant at 5% and 10% level, respectively. is first difference. is second

difference. CPI is an inflation (t). ECMt-1 is one period lagged error correction term. Batteries of diagnostic tests

were applied for each equation. The ECM passed most of the diagnostic tests including serial correlation,

functional form and heteroscedasticity (The results are available on request).

According to Table 4 and Table 5, the significant coefficient for the error correction term is an

indication that neglecting the cointegratedness of the variables, which could introduce a serious

misspecification in the dynamics relationship. The results of the ECM M1 and M2 indicating

inflation rate, real income, interest rates and lending rates are cointegrated. The small magnitude of the

coefficient for ECM t-1 indicates that the adjustment toward equilibrium is rather slow. In short-run, the

inflation rate, real income, interest rates and lending rates are statistically significant and have

177

corrected sign for ASEAN countries, namely Indonesia, Malaysia, Philippine, Singapore and Thailand;

except real income of M1 of Philippines and Indonesia are not significance.

6. Conclusions

The purpose of this study is to investigate the demand for money in the five ASEAN developing

countries. The relationship between real money balances and its determinant is not a new research

topic and it frequently yields mixed result. However the studies are never ending. It is stimulated due

to the structure adjustment and the policy fine-tuning of a particular country, such as, financial

innovation and financial liberalization. Obviously various issues need to be investigated rigorously,

such as the appropriate scale variable (measured of permanent income), the opportunity costs of

holding money and lending rate (measured of the cost of credit).

Estimation of the long run relationship on monetary aggregates was obtained by employing

Engle Granger two-step cointegration technique. However, as to the short-run dynamic relationship on

monetary aggregate and its determinants, error correction model was employed. The estimation runs

through monthly data for the period 1987: month 1 to 2007: month 4.

The cointegration results and ECM result clearly show that there exists a long run and short

run dynamic equilibrium relationships between monetary aggregate (M1 and M2) and real income,

interest rates, inflation and lending rates. Hence, the money demand equation for each country appears

well fitting and structurally stable. This finding suggests that the Central Bank of these five major

ASEAN countries should emphasize the narrow or broad definition of money for monetary control to

achieve their goals. However, this also provides an optional to particular Central Bank to choose either

narrow or broad definition of money, which is more applicable for setting policy, target and achieving

their goals.

Two more findings deserve special mention. First the empirical results show that income

variable exhibits a long-run relationship with real money balances even its affected by timing

differences and re-tested by new estimation technique. Second, a plausible case has been made in

theory that demand for money depend upon the cost of borrowing (lending rate), since borrowing, just

like drawing on precautionary, transaction and speculation balances, is one way of meeting foreseen

and unforeseen expenditure. The empirical results indicate that the money demand model, where the

costs of borrowing (lending rate) are considered, playing a significant role in the standard demand for

money models.

In summary, although not impossible, the five ASEAN countries appear to be relatively

suitable towards integrating the monetary system. Moreover, monetary integration is essential in

ensuring long run regional financial system stability. Future study, concerning proper use of financial

variables as well as monetary variables and proper institutional set up will further identify the correct

structure of the integration.

178

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