Econometric modelling of the relationship between money, income and interest rates in the U.K. : 1963-1978

Abstract

This thesis investigates empirically the relationship between money, income and interest rates in the U.K. over the period 1963 to 1978. After developing univariate models of the time series' proxying these theoretical variables, the paradox existing between the conventional theoretical model, the IS/LM framework, and the usual empirical practice of directly estimating the demand for money function is investigated. It is shown that the crucial issues are the exogeneity assumptions placed on the IS/LM framework. As such assumptions cannot be tested in a static framework, a dynamic analogue of the IS/LM model is developed, along with appropriate methods for testing exogeneity in dynamic multivariate systems. Empirical tests show that the assumptions of the exogeneity of money and government expenditure are invalid, but that the direct estimation of demand for money functions is appropriate. This leads to an investigation of the dynamic structure and functional form of this function using recently developed techniques based on specification search procedures. A major conclusion of this study is that the IS/LM model is an invalid framework for empirical research, and in particular money cannot be regarded as being exogenously determined. Indeed, there is no evidence of feedback from money to either real income or prices, although both statistical and economic reasons are advanced for the possibility that such feedback cannot be detected by the techniques employed. Important short run dynamic effects are found on the demand for money with respect to real income, prices and interest rates. Furthermore, both the wage rate and an own rate of interest variable are also important determinants of money demand. The demand for narrow money function also exhibits sensible long run behaviour and has an adequate predictive performance but, unfortunately, the broad money function has no long run properties and predicts unsatisfactorily