Money Demand and Economic Uncertainty

Abstract

The author examines the impact of economic uncertainty on the demand for money. Using a general-equilibrium theory, he argues that in a world inhabited by risk-averse agents, who are constantly making portfolio decisions against a backdrop of macroeconomic uncertainty, the demand for money is a function of real income and interest rates, and an index of economic uncertainty. The author then uses the Johansen procedure of cointegration to estimate the long-run stationary relationships between a Canadian monetary aggregate (M1, M1++, and M2++) and the explanatory variables. Allowing for an index of economic uncertainty to enter the short-run dynamics of the estimated model, the author obtains empirical results that show that, in general, increased economic uncertainty leads, in the short run, to a rise in the desired M1 and M1++ balances that agents would like to hold. The impact of economic uncertainty on M2++ is, however, observed to be negative.

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