Demand for M2 in Developing Countries: An Empirical Panel Investigation

A significant body of literature on developed countries support the view that disequilibrium in the money market can affect the future output gap and/or inflation. This paper examines the major determinants of the demand for real money balances in eight developing countries for which consistent annual time series data are available. Pooling cross-country and time series data for the 1979-1999 periods and employing the seemingly unrelated regression (SUR) estimation technique, this paper models a standard money demand function. Various country-specific coefficients are allowed to capture inter-country heterogeneities. Consistent with theoretical postulates, this paper finds that the demand for money positively responds to an increase in real income and negatively to a rise in the interest rate spread, the rate of inflation and the US long-term interest rate. This study supports the hypothesis that disequilibrium in the money market can exacerbate inflation and widen the output gap.