Money Demand Functions for Pakistan (Divisia Approach)

The money demand function plays a key role in monetary policy formulation. Pakistan economy witnessed severe monetary problems in last few years, which call for a thorough investigation of the root cause. The study tried to estimate money demand function using Divisia type-weighted aggregates, instead of Simple sum official aggregates. Both long run and short run money demand functions were estimated and Stability was also tested. The money demand function based on broader Divisia aggregate (DivM2) was found to be the stable money demand function for Pakistan. The results indicated that the Divisia based money demand estimates were more realistic and had more information content. The study suggested that State Bank of Pakistan should abandon the Simple sum aggregation technique and switch over to the Divisia aggregates, which have more aggregation theoretic foundations.