Christopher Adam, Pantaleo Kessy, Johnson J. Nyella and Stephen A. O'Connell The demand for money in Tanzania Discussion paper [or working paper, etc.] Original citation: Adam, Christopher and Kessy, Pantaleo and Nyella, Johnson J. and O'Connell, Stephen A. (2010) The demand for money in Tanzania. International Growth Centre, London, UK. This version available at: http://eprints.lse.ac.uk/36393/ Originally available from International Growth Centre (IGC) Available in LSE Research Online: May 2011 © 2011 The Authors LSE has developed LSE Research Online so that users may access research output of the School. Copyright © and Moral Rights for the papers on this site are retained by the individual authors and/or other copyright owners. Users may download and/or print one copy of any article(s) in LSE Research Online to facilitate their private study or for non-commercial research. You may not engage in further distribution of the material or use it for any profit-making activities or any commercial gain. You may freely distribute the URL (http://eprints.lse.ac.uk) of the LSE Research Online website. The Demand for Money in Tanzania 1 Christopher S. Adam, Pantaleo J. Kessy, Johnson J. Nyella, and Stephen A. O‟Connell March 26, 2010 ABSTRACT We develop an econometric model of the demand for M2 in Tanzania, using quarterly data from 1998 to the present. The continuous decline in velocity since the late 1990s is associated with a transformation of economic activity that has cumulatively increased the monetary intensity of GDP. Portfolio behavior also responds to expected inflation and to exchange rate depreciation, with weaker effects from interest rates. The components of M2 respond to opportunity costs as expected, with currency more sensitive to expected inflation and deposits more sensitive to the interest rate on government securities. We discuss the policy implications of our results, including their relevance to the velocity-forecasting exercise that plays a key role in the Central Bank of Tanzania‟s policy framework. This paper is the outcome of research collaboration between staff of the Bank of Tanzania and the International Growth Centre. The views expressed in this paper are solely those of the authors and do not necessarily reflect the official views of the Bank of Tanzania or its management. All errors are those of the authors. 1 Adam, Oxford and IGC; Kessy, Bank of Tanzania and IGC; O‟Connell, Swarthmore and IGC; Nyella, Bank of Tanzania. Contents 1. Introduction ................................................................................................................................ 3 2. The Tanzanian setting ................................................................................................................ 4 Trends in velocity ............................................................................................................................ 5 Composition of the aggregates ....................................................................................................... 6 Key features .................................................................................................................................... 7 3. Existing work on money demand in Tanzania........................................................................... 8 4. The demand for M2 ................................................................................................................. 11 Incorporating structural change................................................................................................... 13 Long-run estimates........................................................................................................................ 14 Short-run dynamics ....................................................................................................................... 15 5. Currency and deposits .............................................................................................................. 16 6. Forecasting velocity ................................................................................................................. 17 Within-sample performance.......................................................................................................... 18 Out-of-sample forecasting ............................................................................................................ 22 7. Conclusions and Implications for Monetary Policy................................................................. 22 References ..................................................................................................................................... 25 Tables and Figures ........................................................................................................................ 28 Appendix 1. Macroeconomic Developments, 1966-95 ............................................................... 42 Appendix 2. Motivating the demand for money .......................................................................... 46 Appendix 3. Definitions and sources of variables ....................................................................... 48 Appendix 4. Phillips-Perron Unit root tests ................................................................................. 49 1. Introduction The Bank of Tanzania (BoT) uses a monetary aggregate as its intermediate target for monetary policy, on the grounds that portfolio equilibrium induces a reasonably predictable relationship between money and prices in Tanzania. The fulcrum of this relationship is the private sector‟s demand for money. If this is a stable function of observable variables, then a policy that targets the growth of nominal money has some prospect of stabilizing inflation at desired levels and at reasonable cost in terms of other variables. But if the demand for money is subject to large and unpredictable shifts, an approach that places less emphasis on money growth may produce superior macroeconomic outcomes. Instability of money demand is widely viewed as having contributed to the demise of money-targeting frameworks among the industrial and emerging-market economies and their replacement since the early 1990s with variants of inflation targeting (Freedman and Laxton 2009). While the demand for money has been the subject of considerable research within Tanzania, data constraints are severe and the published literature is relatively small. Econometric models currently do not play as prominent a role in policy formation as the Bank desires. Forecasts of nominal money demand are required to determine program targets for money base growth, but these generally come down to judgmental extrapolations of trends in velocity. We pose a simple question in this paper: does a stable money demand function exist in Tanzania? Given its prominence in Tanzania‟s monetary framework we focus primarily on broad money (M2). Currency is an unusually large proportion of M2 in Tanzania, however, and recent data suggest that fewer than 10 percent of rural households have a member with a bank account. We therefore disaggregate M2 and present results separately for currency and deposits. Further work is a high priority, including an investigation of M3, which includes foreign-currency deposits, the fastest- growing component of bank liabilities since the mid-1990s. We begin the paper by summarizing some of the key features of portfolio behavior in Tanzania. Section 3 reviews existing econometric work on money demand. In 6/7/2010 3 Sections 4 and 5 we present our empirical work, focusing in turn on long-run relationships and short-run dynamics. Section 6 discusses the relevance of our results to the velocity forecasts that underpin the BoT‟s reserve-money program. We conclude in Section 7 with a summary of findings and policy implications. 2. The Tanzanian setting Denoting the log of real M2 by , a conventional demand for money function takes the form ﰀﰀ = ( , , , +1 , +1 , ), (1) ﰀ푾ﰀ 풛풕 ﰀﰀ ﰀ ﰀ휋 ﰀ 풕 풊풕 ﰀﰀ ﰀ ﰀﰀ 푨푳푻 풊 where is a scale variable, typically the log of real GDP, and are row vectors expected ﰀ푾 theﰀof interest rates on alternative assets and the components of 푨푳푻, E[.] is 풊M2 풊 ﰀﰀ value operator, is the inflation rate, is the rate of nominal depreciation, and is a 2 .( ﰀterminants (Ericsson 1998ﰀvector of other de 풛 ﰀ 휋 As alternative scale variables, we consider real GDP and gross national expenditure (GNE); both serve as proxies for the transactions demand for money.3 The two variables behave similarly over time, but differences due to aid, terms of trade effects, and private capital flows can sometimes be substantial. In the end our empirical results favor real GDP. The menu of alternative assets includes claims denominated in foreign currency, domestic government securities, and inventories of goods. Foreign currency was widely traded during the exchange-control period and has been legal since the early 1990s. Foreign-currency deposits were introduced in the early 1990s and now account for nearly a third of total M3. Capital controls continue to prohibit the accumulation of offshore assets, but the effectiveness of these controls is uncertain and there may well be substantial dollar balances abroad. We use expected depreciation as our main measure of the return on assets denominated in foreign currency. Domestic government securities are 2 The theory underlying this specification is discussed in more detail in Appendix 2. 3 Theory suggests a role for financial wealth as well, and recent work on