Money Demand in an Open-Economy Shopping-Time Model : An Out-of-Sample-Prediction Application to Canada

This paper develops a shopping-time model in an open economy framework to motivate the specification of money demand. This microfoundations-of-money model allows me to choose which variables, and in what forms, should be used in the empirical money demand function. In particular, the model includes the real exchange rate and foreign interest rates and distinguishes explicitly between consumption of imports and consumption of domestically produced goods. In addition, the model implies several long-run relations among relevant variables that can be utilized in the short-run dynamics of the money demand function. Based on this model, Canadian quarterly data for the period 1971:1-1997:2 are used to evaluate the out-of-sample prediction performance of the model. The results show that an error-correction representation of the model performs significantly better than several unrestricted and traditional open- and closed-economy models in the out-of-sample prediction of Canadian real M1 demand