The Monetary Method to Measure the Size of the Shadow Economy. A Critical Examination of its Use

The monetary method is a widely used approach to measure the size of the shadow economy. It is based on the hypothesis that cash is used to make transactions that agents want to keep hidden from official records. This paper (i) provides a formal aggregation framework which stylizes the steps usually followed in empirical applications and makes clear the assumptions required by this method, (ii) demonstrates that the method has been used implicitly assuming that the income-elasticity of currency demand is one even in those cases in which its econometric estimate is not one, (iii) shows that when the money demand function used to estimate the size of the shadow economy includes the lagged dependent variable, the need to assume a known initial condition reappears, as it was the case in the early monetary method.