A STABLE MONEY DEMAND FUNCTION FOR ZIMBABWE AS A PRE-REQUISITIE FOR EFFECTIVE MONETARY POLICY FORMULATION

Robson Roy Jubenkanda

Abstract


The analysis of monetary aggregates is one of the pillars of Zimbabwe’s monetary policy strategy since money growth is highly correlated with inflation. Consequently monetary authorities use money growth as one indicator for future risks to price stability. A stable money demand function is therefore a critical prerequisite for effective monetary policy formulation. This study using time series quarterly data for Zimbabwe over the sample period 1980:1 to 1990:4 investigated the rationale for including either foreign interest rates (three months (LIBOR) or expected exchange rate or both (proxying for international capital mobility) in Zimbabwe’s money demand function in order to achieve structural stability and hence an appropriately specified money demand function. A key innovation was the inclusion of foreign interest rates and expected exchange rate in Zimbabwe’s money demand function in order to capture the openness of the economy. The monetarist view, Keynesian view and the structuralist view of price stability formed the core of the literature review. Utilizing the multivariate cointegration approach, the study applied the error correction model as the main tool of analysis. Selection of the suitable variables that entered the estimating equation used the Vector Auto Regression (VAR) procedure. The model was estimated by Ordinary Least Squares (OLS). The results showed that it was the expected exchange rate that entered the estimated equation for Zimbabwe’s money demand function more appropriately than the foreign interest rate. This approach yielded a predicted path of M1 velocity that closely matched the data. The results further indicated that there was cointegration among the variables in Zimbabwe’s money demand function. The applied tests supported the stability of the estimated model.

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