A Money Demand Function with Output Uncertainty, Monetary Uncertainty, and Financial Innovations

In a general equilibrium framework incorporating the money-in-the-utility function approach, we show that output uncertainty and monetary uncertainty as well as output, interest rates, and financial innovations affect money demand. The estimated long-run relationships are consistent with our postulated relation but not with the conventional one. Our model delivers a high income elasticity consistent with cross-sectional evidence and helps resolve M1 demand puzzles. The model estimated in dynamic error correction form exhibits a good level of stability and forecastability, providing little support for the recent de-emphasis of monetary aggregates due to the instability of money demand.