Estimation of Long-run Demand for Money: An Application of Long-run Structural Modelling to Saudi Arabia

Using a portfolio balance approach, this paper makes an initial attempt to examine the importance of international factors, such as foreign interest rate and nominal effective exchange rate, on the stability of long-run money demand function in an open developing economy with free capital movement. Saudi Arabia is taken as a case study over the period (1986-2004). The method applied is the ‘Long Run Structural Modelling’ (LRSM) (Pesaran and Shin, Econometric Reviews, 2002) which has tried to address the atheoretical nature of a lot of conventional cointegrating estimates. The stability of the functions has also been tested by CUSUM and CUSUMSQ. Our findings tend to suggest that the foreign interest rate and the nominal effective exchange rate (on top of the real income and domestic interest rate) have significant effects on the stability of the long-run money demand function of M3 and M2, respectively. The results are indicative of the significant effects of capital mobility and/or currency substitution in the broad money demand functions. A clear policy implication is that a failure to incorporate these two international factors in the money demand function may result in the function being unstable and the monetary policy being far less effective.