Partial Adjustment in the Demand for Money: Theory and Empirics

Abstract

Central to the notion of money as the medium of exchange is the concept that all transactions are conducted using money balances. This notion, expounded most explicitly by Robert Clower (1967, 1970), has led to the development over the past decade of interesting models of the transactions and precautionary demand for money.' These have examined optimal behavior of the economic agent in steady state. Although there has been much gained by examining money balance behavior in this way, money demand models so far have ignored the behavior of money during periods of disequilibrium. An adequate understanding of total money balances is possible only by incorporating both equilibrium and disequilibrium behavior into an overall view. In this regard, Michael Darby (1972) is exceptional in explicitly treating disequilibrium money demand behavior. Darby's paper is mainly empirical, but it contains an interesting intuitive discussion of money's role as a during periods of disequilibrium. In the present study, we address both the theoretical foundation and empirical importance of the shock absorber effect. We construct a model of optimal behavior by the economic agent, showing the necessary conditions for the existence of partial adjustment and indicating how the intensity of adjustment behaves over time and in response to changes in economic variables. This appears to be the first such attempt in the money demand literature, although there is related work in the investment literature on the flexible accelerator. We test the model on U.S. quarterly data to estimate the existence and magnitude of partial adjustment. We find a significant but small effect for both Ml and M2; furthermore, the effect dies out within one and two quarters for the respective definitions of money. The results thus support, but disagree in magnitude, with those of Darby (1972), who found a larger and longer-lasting partial adjustment effect. Our finding of so short an effect is especially important in light of Robert Barro's (1978) paper which relies on Darby's long-lasting effect to explain price behavior.

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