Stability of Money Demand Function in Pakistan

Abstract

This paper is an attempt to contribute to the ongoing debate, if central bank of Pakistan should adopt the inflation targeting or should continue with the monetary targeting, monetary policy strategy. A prerequisite for monetary targeting strategy is a stable money demand function, which in turn requires stability in velocity. Instability in velocity on the other hand is believed to stem from the volatility of the interest rate. Therefore purview of this paper is to check the stability of velocity of money. Estimation shows that 'base' and 'broad' money velocity's are independent of the interest rate fluctuations. The results further confirm that all three velocities have stable relationship with its determinants. These findings validate use of monetary aggregates as 'nominal anchor'. As policy implication, this paper does not find support for those arguing that the central bank should abandon the monetary targeting monetary policy strategy against inflation targeting. JEL Codes: E12, E5