The Pedroni (2000) panel cointegration method is used to estimate the cointegrating equations for the demand for narrow money for a panel of five Pacific Island Countries (Fiji, Samoa, Solomons, Vanuatu and Papua New Guinea) for the period 1975-2007. The effects of financial reforms are analyzed with estimates from sub-sample periods. Our results suggest that there is a unique cointegrated long run relationship between real narrow money, real income and nominal rate of interest. The major finding is that the money demand function has been stable and financial reforms are yet to have any significant effects in the Pacific Island Countries.Demand for money, income elasticity, semi-interest rate elasticity.

Saten Kumar

English

Research Papers in Economics

EERI
Economics and Econometrics Research Institute 
EERI Research Paper Series No 12/2010 
ISSN: 2031-4892 
Copyright © 2010 by Saten Kumar 
Panel Data Estimates of the Demand for Money in the 
Pacific Island Countries 
Saten Kumar 
EERI
Economics and Econometrics Research Institute 
Avenue de Beaulieu 
1160 Brussels 
Belgium
Tel: +322 299 3523 
Fax: +322 299 3523 
www.eeri.eu1
Panel Data Estimates of the Demand for Money 
 in the Pacific Island Countries 
Saten Kumar  
School of Economics, Auckland University of Technology, New Zealand 
Abstract 
The Pedroni (2000) panel cointegration method is used to estimate the cointegrating 
equations for the demand for narrow money for a panel of five Pacific Island Countries 
(Fiji, Samoa, Solomons, Vanuatu and Papua New Guinea) for the period 1975-2007. The 
effects of financial reforms are analyzed with estimates from sub-sample periods. Our 
results suggest that there is a unique cointegrated long run relationship between real 
narrow money, real income and nominal rate of interest. The major finding is that the 
money demand function has been stable and financial reforms are yet to have any 
significant effects in the Pacific Island Countries.
Keywords: Demand for money, income elasticity, semi-interest rate elasticity  
JEL Numbers: E41 and C33 
Acknowledgements: The author is grateful to Professors Alfredo Garcia Hiernaux, 
Emmanuel Anoruo, Gbadebo Odularu and Ilhan Ozturk for comments. 
Contacting author: Saten Kumar, School of Economics, Auckland University of 
Technology, New Zealand. Email: kumar_saten@yahoo.com.  2
1. Introduction 
The stability of the demand for money function is vital because it has implications for the 
implementation of monetary policy. According to Poole (1970), rate of interest should be 
targeted if the LM curve is unstable and money supply if the IS curve is unstable. Since 
the instability in the demand for money is a major factor causing instability in the LM, it 
is vital to test the stability of the money demand function. In other words, money supply 
is to be targeted if the demand for money is stable. There are few studies that have 
examined the stability of the money demand in the Pacific Island Countries (henceforth 
PICs), however, none have used the panel cointegration techniques. Some of these 
studies include Katafono (2001), Jayaraman and Ward (2003), Rao and Singh (2005), 
Rao and Kumar (2007), Kumar and Manoka (2008) and Singh and Kumar (2009a and b). 
These studies have utilized the time series techniques and their central focus has been on 
Fiji. With the exception to Katafono (2001), others have supported the stability in the 
money demand functions in the PICs. For a comprehensive review of these studies, see 
Singh and Kumar (2009a).   
The objective of this paper is to estimate the money demand relationship for five PICs 
with the Pedroni (2000) panel Fully Modified Ordinary Least Squares (FMOLS) 
technique. Most importantly, it is worth examining whether the financial reforms 
implemented in the PICs during the mid to late 1980s had any significant effects on their 
demand for money functions. To the best of our knowledge, this is the first paper to 
examine this issue for the PICs within a panel data framework. Our data is from 1975 to 
2007 for Fiji, Samoa, Solomons, Vanuatu, and Papua New Guinea (PNG). Section 2 
provides the specification of the demand for money and briefly discusses the data. 
Empirical results are detailed in Section 3. Section 4 concludes.  
2. Specification and Data 
The standard specification for the demand for money in many cointegration studies is
1:
ln ln                            (1) it i it it it it it MY R      
where lnM is the log of real money (M1), lnY is the log of real GDP and R is the 
nominal short term rate of interest (1-3 year savings deposit rate). 
Our panel data consists of five PICs ( 1....5) N  for the period 1975 to 2007 ( 1.....33). T 
The selected countries are Fiji, Samoa, Solomons, Vanuatu and PNG. We started through 
testing for the presence of unit roots in the three variables, namely lnM,l n Y and R using 
the panel unit root tests of Levin, Lin and Chu (2002, LLC), Breitung (2000), Im, Pesaran 
and Shin (2003, IPS), ADF Fisher 
2   (ADF), PP Fisher 
2  (PP), and Hadri (2000).  The 
panel unit root test results are given in Table 1. 
1 We have ignored the inflation rate because unit root tests showed that inflation is a stationary variable. 
The exchange rate is also ignored and foreign exchange holding is not a practical option in many PICs.  3
Table 1. Panel Unit Root Tests 1975-2007 
Series LLC  Breitung  IPS  ADF  PP  Hadri 
lnM -0.336 
(0.87) 
-3.006 
(0.56) 
1.065 
(0.45) 
8.965 
(0.27) 
2.753 
(0.02)* 
9.523 
(0.00)* 
lnY -1.288 
(0.98) 
-4.112 
(0.62) 
-1.335 
(0.93) 
3.224 
(0.11) 
27.847 
(0.31) 
6.045 
(0.00)* 
R -1.736 
(0.36) 
-0.946 
(0.46) 
0.112 
(0.72) 
1.083 
(0.34) 
7.294 
(0.45) 
0.375 
(0.00)* 
	 lnM -12.740 
(0.00)* 
-19.018 
(0.00)* 
-1.140 
(0.00)* 
2.373 
(0.00)* 
8.028 
(0.00)* 
8.233 
(0.00)* 
	 lnY -9.836 
(0.00)* 
-10.736 
(0.00)* 
-11.012 
(0.00)* 
2.527 
(0.00)* 
15.828 
(0.00)* 
1.003 
(0.00)* 
	 R -4.617 
(0.00)* 
1.626 
(0.00)* 
0.823 
(0.00)* 
5.264 
(0.00)* 
17.932 
(0.00)* 
4.025 
(0.00)* 
Notes: Probability values are reported in the parentheses. * denotes the rejection of the null at the 5% level.  
For the variable lnM, the LLC, Breitung, IPS and ADF tests in which the null is that the 
variable is non-stationary is not rejected at the 5% level. However, in the PP test in which 
the null is the same accept the null at only the 1% level. In the Hadri test the null is that 
the variable is stationary and it is rejected at the 5% level. For the variables lnY and R, all 
the tests show that they are non-stationary at the 5% level. Alternatively, with the 
exception of the Hadri test, all other tests show that the first differences of lnM,l n Y and R
are stationary. Therefore, it is reasonable to conclude that these variables are by and large 
I(1) in their levels.  
3. Empirical Results 
We have estimated equation (1) for the entire sample period (1975-2007) and sub-sample 
periods (1975-1989 and 1990-2007). We have selected 1990 as the break date because 
financial reforms were implemented in the PICs in late 1980s and early 1990s.
2 If 
financial reforms have been effective, it is to be expected that there would be a structural 
break in the cointegrating equation after the mid 1980s. From the demand for money 
perspective there should be some improved economies of scale meaning that the income 
elasticity should show a decline and an improvement in the responsiveness of money 
demand to changes in the rate of interest because of more market based interest rate 
policies and improved capital mobility. 
The results of the panel cointegration tests are reported in Table 2. In the fixed effects 
model, the majority of the cointegration tests show that there is cointegration between 
lnM,l n Y and R at the 5% level. Only the Panel 
 - test statistics in the fixed effects 
model is insignificant at the 5% level. All the cointegration tests for the random effects 
model reject the null of no cointegration, except Group 
 - statistics in the sub-sample 
periods. Nonetheless we can infer that lnM,l n Y and R are cointegrated. 
2 We also attempted to use break dates as 1985 and 1988 but 1990 appeared to give the robust results. The 
results for 1985 and 1988 are not reported to conserve space. 4
Table 2.  Panel Cointegration Tests 
Test Statistic  Fixed Effects Model  Random Effects Model 
  1975-2007 1975-1989 1990-2007 1975-2007 1975-1989 1990-2007 
Panel  - statistic  2.465* 3.925* 3.721* 4.737* 3.882* 2.806* 
Panel 
 - statistic  -1.003  0.116 1.207 -2.488*  2.201*  7.004* 
Panel  - statistic  -2.393* 2.091*  10.762* -3.007* 2.112*  3.150* 
Panel  ADF-statistic  -10.837*  2.342* 2.226* -6.165*  18.732*  2.312* 
Group 
 - statistic  -13.009*  9.726* 3.244* -5.054*  1.013  0.956 
Group  - statistic  -2.627*  5.006* 3.245* -9.036*  4.544* 2.110* 
Group ADF- statistic  -4.974*  4.276* 3.828* -4.945* 8.920*  5.673* 
Notes: The test statistics are distributed as N(0,1).  * denotes significance at 5% level. 
The results for the panel long run estimators using panel FMOLS are reported in Table 3. 
The income elasticity of the money demand is around unity and the semi-interest rate 
elasticity is around -0.02. Estimates for the sub-samples with 1990 as the break date show 
that there are no significant variations in the income and semi-interest rate elasticities. On 
the basis of these results we infer that there is no structural break and instability in the 
demand for money in our panel of five PICs. If the long run demand for money for the 
individual countries shows instability, for which there is no evidence as yet, financial 
reforms are not a major cause for such instability. This conclusion is consistent with 
Singh and Kumar’s (2009b) findings that money demand functions have been fairly 
stable in the PICs and with the other recent findings of Rao and Kumar’s (2009) and 
Bahmani-Oskooee and Rehman’s (2005) for Asian developing countries. This implies 
that using the interest rate as the monetary policy instrument by the central banks of PICs 
is somewhat premature, inappropriate and may actually accentuate economic instability. 
Table 3: Estimates of the Cointegration Coefficients  
Fixed Effects Model  Random Effects Model 
1975-2007 1975-1989 1990-2007 1975-2007 1975-1989 1990-2007 
lnY 0.954 
(10.72)* 
1.034 
(2.15)* 
0.975 
(5.54)* 
1.005 
(5.92)* 
1.059 
(4.87)* 
0.977 
(15.97)* 
R -0.017 
(7.65)* 
-0.020 
(8.06)* 
-0.024 
(4.25)* 
-0.025 
(9.53)* 
-0.019 
(3.05)* 
-0.022 
(10.53)* 
Notes: The t-ratios are in the parentheses and * indicates significance at 5% level. 
4. Conclusion
In this paper, we have estimated the demand for real narrow money for five PICs (Fiji, 
Samoa, Solomons, Vanuatu and PNG) with the Pedroni (2000) panel cointegration 
technique. Estimates for the entire sample period of 1975 to 2007 showed that income 
elasticity of demand for narrow money is about unity and demand for money responds 
negatively to variations in the short term rate of interest, albeit by a small amount. This 
framework is extended to test if the financial reforms in these countries have had any 
significant effects. Our sub-sample estimates show that reforms do not seem to have had 
any significant effects so far. An implication of our results is that financial reforms are 
not a major contributor to the instability in the demand for money. Further, there is no 
evidence to say that the long run demand for money has become unstable because 
cointegration tests for the sub-samples reject the null of no cointegration. Therefore, 5
central banks of the PICs should use money supply as their monetary policy instrument to 
achieve their policy targets like a moderate inflation rates and overall economic stability.  
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Panel Data Estimates of the Demand for Money in the Pacific Island Countries

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