Higher Dimensional VECM Models with Long-Run Money Demand Functions

Abstract

In the previous chapter, we analyzed various specifications of vector error correction models that involve three variables: real money balances, real income, and the Treasury bill rate. It was determined that there is one cointegrating vector among these variables, so there are two permanent shocks and one transitory shock that affect these three variables. The size of the model makes it impossible to attribute any economic interpretation to the transitory shock. In this chapter, the dimension of the VECM is increased to four variables. Two different specifications of such models are examined. In one the inflation rate is added to the vector of variables considered in Chapter 6, and questions of stationarity or nonstationarity of the real interest rate and the presence of absence of a long-run Fisher effect in the U.S. data are investigated. In the second model a long-term rate of interest is added to the vector of variables previously examined, and questions of the role of the term structure in affecting the demand for real balances and the elasticities of the demand for real balances with respect to long and short-term rates of interest are investigated. In both cases there is evidence for a second cointegrating vector. Restrictions on the second vector to a real interest rate or an interest rate spread, respectively, are not rejected. The estimated interest semielasticity of the velocity cointegrating vector is robust to this expansion of the model.