Financial Services, Cointegration, and the Demand for Money in Israel

The main hypothesis of this study is that ignoring the state of the financial services in the demand for money is a theoretical misspecification and is an important reason for the instability of the money demand as traditionally estimated. A measurement approach for the state of the financial services is developed and applied to estimation of the demand for money in Israel. The approach presented in Melnick (1990) is further developed by analyzing the lack of cointegration between real balances and their determinants according to theory as a case of omitted variables in a nonstationary time-series set-up. When our measure for the state of the financial services is included, it yields a stable, cointegrated, long-run demand far money relationship. The validity of steady-state inflation-tax analysis is questioned and a negative recommendation for the use of quantitative money targets is given. Copyright 1995 by Ohio State University Press.