DEFINITION OF MONEY:

Money is any commodity or token that is generally acceptable as a means of payment. A means of
payment is a method of settling a debt.

The definition given by economics describes money through the functions that it performs:

D.H. Robertson: “Money is everything which is widely accepted in payment for goods or in discharge
of other kinds of business obligation”.

Kent: “Money is anything which is commonly used and generally accepted as medium of exchange or
as standard of value”.

Crowthers: “Money may be defined as anything that is generally acceptable as means of exchange and
that at the same time acts as a measure and as a store of value”.

Coulborn: “Money may be defined as a means of valuation and of payment”.

There are three approaches to the definition of money:

Traditional approach: Money is regarded only as a medium of exchange. This definition emphasizes
on the liquidity aspect of money and is expressed as

M= C+D

(M includes currency and D stands for demand deposits)

Monetarist approach: Money is a temporary adobe of purchasing power. Money includes currency
(C), demand deposits (D) and time deposits, (T) = M=C+D+T.

Liquidity approach: The measurement of money all the assets which are highly liquid, i.e. the assets
which can be converted into money quickly. According to this approach Money (M), includes currency
(C) demand deposits (D), time deposits (T), saving bank deposits (SB), shares (S) bonds (B) etc.

M=C+D+T+SB+S+B etc.

M = money

M1 = Currency in circulation + demand deposits with schedule banks and other deposits with SBP.

M2= M1 + time deposits with scheduled banks.

M3= M2 +NDFC bearer certificates + deposits of national saving schemes + deposits of co-operative
banks.

1
TYPES OF MONEY:
In economics, money is a broad term that refers to any financial instrument that can fulfill the functions of
money (detailed above). Modern monetary theory distinguishes among different types of monetary
aggregates, using a categorization system that focuses on the liquidity of the financial instrument used as
money.

Commodity money:
Commodity money value comes from the commodity out of which it is made. The commodity itself
constitutes the money, and the money is the commodity. Examples of commodities that have been used as
mediums of exchange include gold, silver, copper, rice, salt, peppercorns, large stones, decorated belts,
shells, alcohol, cigarettes, cannabis, candy, barley, etc.

Representative money:
Representative money is money that consists of token coins, other physical tokens such as certificates,
and even non-physical "digital certificates" (authenticated digital transactions) that can be reliably
exchanged for a fixed quantity of a commodity such as gold, silver or potentially water, oil or food.

Credit money:
Credit money is any claim against a physical or legal person that can be used for the purchase of goods
and services. Credit money differs from commodity and fiat money in two ways: It is not payable on
demand (although in the case of fiat money, "demand payment" is a purely symbolic act since all that can
be demanded is other types of fiat currency) and there is some element of risk that the real value upon
fulfillment of the claim will not be equal to real value expected at the time of purchase

Fiat money:
Fiat money is any money whose value is determined by legal means. The terms fiat currency and fiat
money relate to types of currency or money whose usefulness results not from any intrinsic value or
guarantee that it can be converted into gold or another currency, but instead from a government's order
(fiat) that it must be accepted as a means of payment

2
SIGNIFICANT, IMORTANCE & ECONOMIC ROLE OF MONEY:
Money has required immense significant and importance of money is briefly discussed below:

1) Money in production: Money has made possible to produce large number of gods with different
varieties. It helps the produces to purchase the raw materials, combine different factors of production and
make payments to them.

2) Money and consumption: Money helps consumers to get maximum satisfaction from his
available resources. It gives consumer to power to make purchases of goods.

3) Money and trade: Money has helped in removing all the defects and shortcomings of barter
economy. Prices are now freely determined with the help of money. Due to money, there is significant
flow of internal and foreign trade in an economy.

4) Money and distribution: Income to the different factors of production is made in terms of money.
Money has made possible to work out the marginal productivity of each factor of production.

5) Saving and investment: Money plays an important role in the saving investment process in the
economy. Money encourages people to save from their earned income. Money increases the capital
formation in the country which contributes to economic growth.

6) Money and public finance: Money plays an important role in fiscal management. The importance
of money can be judged from the fact that budgets are prepared by the governments through the allocation
of money.

7) Social importance of money: Money is a mean of social reform and social progress. The welfare of
the masses can increase with the help of money.

8) Political progress: Money is also significant in politics. It protects and promotes the welfare of the
people through the use of money. The bilateral and multilateral agreements are also made through the
money.

9) Money as an index of growth: The progress of the company can easily be measured with the help
of money. The per capita income, the remuneration to the factors of production, the flow of national
income etc, are measured in the terms of money. Money is thus an index of growth.

3
BARTER SYSTEM:
At an early at stage of man’s economic life, the wants were very limited in number. Man could easily
satisfy all his wants with what he produced himself. But as time passed, his, needs, began to increase and
he lost his self-sufficiency. He began to exchange some of his products which he had in excess with those
who had surplus products with themselves. Direct exchange of commodity for commodity without the use
of money is termed as Barter in Economics.

Barter is workable in backward as well as advanced countries. It exists more in economically backward
and commercially under-developed areas of the world. In many areas of the Pakistan villages, the
payment to village artisan is still made in kind. Women and children in the villages get villages get sugar,
cloth spices, toys etc. In advance countries of the world, we do not come across the exchange of this type
in their daily business. It is because the range of wants and the range of commodities are so wide that it is
actually impossible to satisfy them through a direct exchange of goods. In modern economy, inside the
country goods are not exchanged for goods but for money.

Now-a-days due to exchange difficulties some advanced countries are entering into a barter deal with
other countries. Pakistan entered into barter deal with communist countries particularly with China and
Russia.

THE FUNCTIONS OF MONEY:

In modern economics, money is used as means of paying for goods and services and paying for labor,
capital and other resources. There are four different functions of money:

Money acts as:

a) A means of exchange

b) A unit of account

c) A standard of deferred payment

d) A store of value

4
a) A means of exchanges:

This is arguably the most important function of money in an economy, because without money, the only
way exchanging goods and services would be by means of barter, i.e. by a direct exchange of goods and
services. In other words, if a shoemaker wanted to buy a horse, he would have either:

a) To find a horse-owner prepared to exchange a horse for a sufficient quantity of shoes of equal value to
the horse or else.

b) To find other people willing to exchange different goods (e.g. food, clothes etc.) for shoes, and then
trade these goods in exchange for a horse from the horse-owner.

A monetary economy is the alternative to a barter economy, and it is a means of encouraging economic
development and growth.

b) A unit of account:

Money should be able to measure exactly what something is worth. It should provide agreed standard
measure by which the value of different goods and services can be compared.

For example: Suppose that only four products are trades in a market. These are cows, sheep, hens and
corn. The relative value of these products must be agreed before exchange can take place in the market.

It might be decided that:

a) 1 cow has the same value as 0.75, 3 hens or 1.5 bags of corn;

b) 1 sheep is the same value as 1.33 cows, 4 hens or 2 bags of corn;

c) 1 hen is worth 0.33 cows, 0.25 sheep or 0.5 bags of corn;

b) 1 bag of corn has the same value as 0.67 cows, 0.5 sheep or 2 hens.

The function of money in the money in the economy would be to establish a common unit of ‘value
measurement’ or ‘account’ by which the relative exchange values or prices of goods can be established.

c) A standard of deferred payment:

In order to provide an acceptable standard for deferred payments, it is important that money should
maintain its value over a period of time. Suppose, for example, that a customer buy goods for an agreed
sum of money, but on three months’ credit. Now if the value of money falls in the three-money credit
period, the sum of money which the seller eventually receives will be worth less than it was at the time of
sale. The seller will have lost value by allowing the credit.

5
One major reason why money might lose value is because of price inflation. When inflation is high:

a) Sellers will be reluctant to allow credit to buyers:

For example: If a buyer asks for three months credit, and inflation is running at 20% per annum, the
‘real’ value of the debt that the buyer owes will fall by about 5% over the three-month credit period;

b) Sellers will be reluctant to agree to a fixed price for long-term contracts:

For example: A house-builder might refuse to quote a price for building a house over a twelve- month
period, said instead insist on asking a price which is “index-linked” and rises in step with general rate of
inflation.

d) A store of value:

Money acts as a store of value, or wealth. So too do many other assets (e.g. land, buildings, art treasures,
motorcars, machinery) some of which maintain or increase their money value over time, and some of
which depreciate in value.

Money is more properly described as acting as liquid store of money. This definition has two parts to it:

a) Money is a store of value or wealth. A person can hold money for an extended period, for the purpose
of exchanging it for services or good or other assets.

b) Money is a liquid asset.

FORMS OF MONEY:
The evolution of money cannot be attributed to a single phenomenon. Historical evidence is available; it
appears that money has evolved indigenously in response to the economic needs of the people. In the
primitive stages of economics development various commodities like fish or cow, knives, etc were
selected to be used as barter unit of value. Today, paper money and bank deposits are our major media of
exchange.

“LIST OF THINGS THAT SERVED AS MONEY”

Clay Rice Earthen pots Copper

Animal teeth Tea Nets Brass
Fish teeth Slaves Boats -------
Cattle Corn Stone Nickel
Horses Salt Iron Bronze
Sheep Bear Silver Paper
Goats knives Gold Debts of banks
Debts of Govt.

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PRINCIPLES AND METHODS OF NOTE ISSUE:
There are two different views regarding the right principle of note issue in the country. One school of
thought advocates full convertibility of notes into gold bullion. The second pleads for elasticity in the
supply of money according to the trade needs.

Currency principle:

According to advocates of the currency principle, the paper money is an economical and
convenient substitute of metallic money. The paper money should have 100% backing of gold
reserves. They are strong view that in order to maintain the prestige of paper money, there should
always be gold available for redemption of notes when presented.

The advantages claimed for this system of note issue are that it gives full safety and security to
the paper currency. There is no danger of over-issue of the currency which is effective check to
the possibilities of inflation.

The disadvantages of the currency principle are that it makes the supply of money highly
inelastic. According to this principle, paper currency can only be printed and issued if there is
100% gold cover available against it. The issue of currency is completely depended upon the
availability of gold rather than on the needs of the trade and industry which is of primary
importance.

Banking principle:

There is no need to have full metallic banking of the paper currency laid down by law. The banks should
be fully relied upon and authorized to regulate the note issue strictly in accordance with the business
needs of the country. There should not be any reserve requirements of gold and silver for the notes issued.
There should be proper ratio will be maintained between the supply of money and the gold reserves. The
banking history of England has numerous instances of monetary mismanagement.

The currency principle and the banking principle, one can easily arrive at a conclusion that both these
system of notes issue are defective. One sacrifices elasticity at the alter of security and the other safety at
the altar of elasticity. Second system of note issue security and elasticity must go side by side. Many
countries have devised new methods of regulating note issue. The new system of note issue is:

a) Fixed fiduciary issue

b) Proportional reserve system

7
THE MONEY SUPPLY AND INFLATION:
The quantity theory of money equation is as follow:

a) If the velocity of circulation of money, V, is more or less constant, then any growth in the money
supply, M, over and above the potential in the economy to increase T, will cause inflation.

b) If output in the economy, T, is growing and if the velocity of circulation, V, is constant, then a
matching growth in the money supply, M, is needed to avoid deflation falling prices).

The quantity theory is that government’s monetary policy should be a allow some growth in the money
supply if the economy is growing, but not to let the growth in the money supply get out of hand. It
depends largely on whether the velocity of circulation of money is roughly constant or not.

For example:

If the money supply increases by 10%, and the ‘real growth’ in the economy (the increase in the volume
of transaction) is 3%, we could predict that inflation will be about 7%- but only if the velocity of
circulation is constant.

The equation or ‘identity’ MV=PT must be correct, but instead of increases in M causing inflation, some
economists would argue that it is inflation which happens first, causing the money supply ton rise in step.
If the money supply does not increase at once, V will increase instead. If the money supply M is
increasing, there might be no longer in PT, and indeed, it could be V that is decreasing.

WHAT MAKES THE MONEY SUPPLY GROWS?

The demand for and supply of money that makes the money supply grow in the first place. The factors
that contribute to money supply growth are:

a) Government borrowing (the public sector borrowing requirement or PSBR)

b) Who the government borrows from, banks or non-banks,
c) Bank lending,
d) Flows of money between the country and foreign traders/investors.

The PSBR is usually positive, adding to the growth in the money supply, because in most years,
the government has been a net borrower of money. A negative PSBR (called a public sector debt
repayment or PSBR) has a contractionary effect on the money supply.

8
KEYNESIAN VIEWS ON THE DEMAND FOR MONEY

Liquidity means assets in the form of cash or near-cash, in particular notes and coin and money in a
current bank account. Liquidity preference refers to the preference of people to hold on to their savings as
money (in liquid form) rather than investing it.

Keynes used argued that if household did not hold their savings in the form of money they would it to
earn interest. The choice was between and bonds.If a people buy bond, they are using their money to
invest. As mentioned earlier, this might seem a bit confusing at first, since you will know that you can
keep money in a bank deposit account or a building society, and earn interest. These ‘grey areas’ between
holding money and investing are ignored, for the basic Keynesian analyses.

Keynes identified three reason or motives why people hold wealth as money rather than as interest-
bearing securities. There are

(a) The transaction motive: households need money to pay for their day to day purchases. The level of
transaction demand for money depends on household’s income

(b) The precautionary motive: people choose to keep money on hand or in the bank as a
precaution for a rainy day when it might suddenly be needed;

(c) The speculative motive; some people choose to keep ready money to take advantage of a
profitable opportunity to invest in bonds which may arise ( or they may sell bonds for when they
fear a fall in bonds market prices)

According to the Keynesian, therefore an increase (or decrease) in the money supply only
indirectly affects the demand for goods and services, and hence the of income, via a change in
the rate of interest.

9
Demand for Money Supply in Pakistan:

Pakistan has achieved a phenomenal growth rate of over 7.5 percent in the past three years.
Money supply also increased at the rate of 9.9 percent in the current fiscal year. Despite tight
monetary policies, inflation continues to increase, especially food inflation. The inflation
adversely affects the poor section of the population. In the wake of high inflation, it seems
imperative to revisit the demand function for money. A time series data for the past 33 years was
analyzed to estimate the demand for money in Pakistan. As the time series are subjected to
various short comings such as non-stationary, autocorrelation and host of other problems; data
were first tested for Co integration and unit root.

The test showed no Co integration and unit root, therefore ECM was not applied. Thus, the data
were analyzed through OLSQ with real money balances as dependent variables and real GDP as
scale variable, interest rate on time deposit, inflation and financial innovations as independent
variables. All coefficients were significant and have expected signs. The long run income
elasticity varied from 0.74 to 0.78 and interest elasticity was -0.464. The money demand function
was stable. The financial innovation parameter was highly significant showing better
management of the monetary policy in the country. The real balance (M2) provided the best fit to
the demand function for money.

Pakistan’s economy has achieved respectable economic growth during the year 2005-06 in the midst of
an unusual increase in oil prices and the destructive seismic activity last year. Pakistani corporate and
consumers continue to be the promising spot. The economic growth was 6.6 percent in the year 2005-
06. Pakistan’s economy has grown at an average rate of almost 7.0 percent per annum during the last
four years (2002/03 – 2005/06) and over 7.5 percent in the last three years (2003/04 –2005/06). The
growth momentum that Pakistan has sustained for the last four years is attributed to dynamism in
industry, agriculture and services, and the surfacing of a new investment turnaround with investment rate
attaining new elevation at 20.0 percent of Gross Domestic Product (GDP) (GOP, 2006).

Pakistan’s economy has achieved further momentum in 2005-06, however, there are some weaker spots
that need to be identified. Firstly there is a sharp increase in the prices of some of the essential food items
in the 2nd half of the fiscal year. There has been a steady deceleration in inflation from over 11 percent in
2005 to 6.2 percent in 2006 and food inflation from 15.7 percent to 3.6 percent in the same period, yet the
prices of some of the essential food items, and some vegetables items have experienced spiky increases,
unfavorably affecting the low and fixed income groups (GOP, 2006).

The simple and favorable monetary policy posture followed during the last few years by the State Bank of
Pakistan (SBP), witnessed considerable shifts during the FY05, changing from a mainly helping to
forceful contraction in the second half of the last fiscal year, more so since April 2005. In order to combat
inflation, the SBP changed its monetary policy stance to aggressive tightening in April 2005 by raising
discount rate from 7.5 percent to 9.0 percent and recently further raised to 9.5 percent (GOP, 2006). The
money supply during current fiscal year increased by 9.94 percent as against 13.37percent in the same
period last year. The pace of monetary expansion remained well within the Credit Plan target for the year
(12.8%) primarily because of the moderate build up in net domestic assets (NDA).

10
The stock of reserve money (RM) also expanded moderately by 9.3 percent compared with an expansion
of 14.9 percent in the same period of last year. The growth of RM remained moderate primarily on
account of substantial trade deficit (GOP, 2006). In the current fiscal year, currency in circulation
increased by 13.6 percent against 17.0 percent and constituted 23.3 percent of the money supply (M1),
compared to 24.1 percent on the same date of last year. The M1/GDP ratio, which is an indicator of
financial development continued to exhibit a rising trend, increasing from 36.9 percent in 1999-00 to 44.9
percent in 2003-04, 45.1 percent in 2004-05, and was 42.1 percent during the year 2006. During the
current fiscal year M0 increased by 7.9 percent as against 16.7 percent last year and M1has recorded a
growth of 9.5 percent compared to 12.7 percent last year. The broad monetary aggregate, M2, has
increased by 7.3 percent during the first 3 quarters of 2005-06, compared to 7.6 percent in the comparable
period last year.

The Data and the Procedure:

The annual data for Pakistan comprised the time period of 1972-2005 (from the State Bank of Pakistan
(SBP). M0 (Reserve Money) consists of currency in circulation + other deposits with the State Bank of
Pakistan + Currency in tills of scheduled Banks + Bank’s deposit with the State bank of Pakistan. M
(Narrow Money) consists of Currency in circulation + other deposits with the State Bank of Pakistan
+Scheduled banks’ demand deposits, and M2 (Broad Money) includes M1+ Scheduled Bank’s
Time deposits + residents foreign currency deposits (GOP, 2006) The data include time series
nominal (M0,M1and M2); gross investment; Gross Domestic Product (GDP) (current prices),
inflation, foreign exchange rate; interest on savings, interest on time deposits; interest rate on
advance; and GDP deflator.

11
Real variables are obtained by deflating nominal variables with GDP deflator. All variables
except inflation rate and interest rates are in logarithmic form. Reserve Money (M0), narrow
money (M1), and broad money (m2) are already defined above.

The Model In this study the long-run real money demand relationship is investigated by the
following models:

M0= f (RGDP, P, I, FI) (1)

M1= f R (GDP, P, I, FI) (2)
M2 = f (RGDP, P, I, FI) (3)

Where:
M0, M1, & M2: the real money demand dependent variables found by dividing nominal money
balances

to GDP deflator;
RGDP: real Gross Domestic Product;
P: the inflation rate;
I: Interest rate on Time deposit as an opportunity cost of holding money; and
FI: Financial Innovation (Ratio of M2/M1).

The application of the Co integration test for money demand requires the examination of time series
properties of the data. Seasonal characteristics of the data are analyzed by using autocorrelation and
partial autocorrelation functions. All the variables included in the co integrating vectors should be
integrated of the same order. The seasonal unit root hypothesis is tested by the DF method developed by
Dickey –Fuller. Dickey and Fuller (1979, 1981) devised a procedure to formally test for non stationarity
through the existence of a unit root. The DF-test is the t-statistic for the lagged dependent variable. If the
DF statistical value is smaller than the critical value then we reject the null hypothesis. In the case of most
tests of Co integration, the hypothesis being tested is the null of ‘non-Co integration’. In this paper, the
relevant hypotheses conceived are:

1. Null Hypothesis (H0): LnM0= Inflation + interest on time deposit + LnRGDP + Ln (M2/M1);
variables in the equation are not co integrated or alternately LnM0contains a unit root.

2. Null Hypothesis (H0): LnM1= Inflation + interest on time deposit + LnRGDP + Ln (M2/M1);
variables in the equation are not co integrated or equivalently that LnM1contains a unit root.

3. Null Hypothesis (H0): LnM2= Inflation + interest on time deposit + LnRGDP + Ln (M

2/M1); variables in the equation are not co integrated or equivalently that LnM2contains a unit root.

12
Test Results:
Co integration
Table 1 through Table 3 show the Trace and the maximal EIGEN value tests using the real M0, real M1
and real M2 According to these tests, for M0, M1 and M2 case we have not found co integrating vector
and all the three null hypotheses were not rejected (p=0.05) meaning there by showing no unit root
indicating that the series are stationery both statistically and economically.

Table 1: Test Statistics for Co integrating Vectors of money demand (M0) in Pakistan:

Co integration Restrictions Test Statistics r=0 r=1 r=2 r=3 r=4

Without Intercept and no Trace Value 117.159* 36.332 20.084 8.367 2.875
Trends Maximal EIGEN *
value 16.247 11.717 5.491 2.875
80.827**

Restricted Intercept and no Trace Value 138.949* 58.064 29.639 14.401 3.313
Trend Maximal EIGEN *
Value 28.425 15.237 11.088 3.313
80.885**

Unrestricted Intercept and no Trace Value 120.602* 50.859 22.878 7.526 2.057
Trend Maximal EIGEN *
Value 27.980 15.352 5.469 2.057
69.742**

Unrestricted Intercept and Trace Value 144.051* 66.819 34.001 16.569 4.212
Restricted Trend Maximal EIGEN *
Value 32.818 17.431 12.357 4.212
77.231**

Unrestricted Intercept and Trace Value 95.650** 50.142 30.211 14.265 3.013
Unrestricted Trend Maximal EIGEN
Value 45.508** 19.930 15.946 11.253 3.012

** show significance at 0.05 probability level Test for real M0, real GDP, inflation, interest on time
deposit, and financial innovations.

13
Table 2:Test Statistics for Co integrating Vectors of money demand (M1) in Pakistan:

Co integration Restrictions Test Statistics r=0 r=1 r=2 r=3 r=4

Without Intercept and no Trace Value 114.673* 34.530 18.196 6.735 2.820
Trends Maximal EIGEN *
value 16.334 11.460 3.915 2.820
80.143**

Restricted Intercept and no Trace Value 137.066* 56.730 28.677 14.092 3.194
Trend Maximal EIGEN *
Value 28.052 14.585 10.888 3.194
80.336**

Unrestricted Intercept and no Trace Value 118.847* 49.872 22.108 7.453 1.984
Maximal EIGEN *
Trend Value 27.764 14.655 5.468 1.984
68.974**

Unrestricted Intercept and Trace Value 141.095* 66.129 33.332 16.308 4.223
Restricted Trend Maximal EIGEN *
Value 32.796 17.024 12.084 4.223
74.965**

Unrestricted Intercept and Trace Value 93.303** 49.575 30.448 14.258 3.021
Unrestricted Trend Maximal EIGEN
Value 43.728** 19.126 16.190 11.237 3.021

** show significance at 0.05 probability level . Test for real M1, real GD, inflation, interest on time
deposit, and financial innovations

14
Table 3: Test Statistics for Co integrating Vectors of money demand (M2) in Pakistan:

Co integration Restrictions Test Statistics r=0 r=1 R=2 r=3 r=4

Without Intercept and no Trace Value 115.324** 34.951 18.326 7.068 2.800
Trends Maximal EIGEN
value 80.373** 16.224 11.657 4,268 2.800

Restricted Intercept and no Trace Value 137.401** 56.875 28.875 14.268 3.230
Trend Maximal EIGEN
Value 80.526** 28.026 14.580 11.038 3.230

Unrestricted Intercept and no Trace Value 118.997** 49.756 22.094 16.441 2.013
Trend Maximal EIGEN
Value 69.241** 27.662 14.597 5.483 2.013

Unrestricted Intercept and Trace Value 141.648** 66.461 33.436 16.441 4.253
Restricted Trend Maximal EIGEN
Value 75.188** 33.025 16.994 12.188 4.253

Unrestricted Intercept and Trace Value 43.403** 19.100 16.219 11.225 3.029
Unrestricted Trend Maximal EIGEN
Value 92.978 49.574 30.473 14.254 3.029

** show significance at 0.05 probability level .Test for real M2, real GDP, inflation, interest on time
deposit and financial innovations

15
Unit Root Test:

The series were also subjected to unit root test individually and with demand equation. Dickey-Fuller,
Augmented Dickey-Fuller, and Nelson and Plosser (1982) tests were applied for unit roots. The following
equation was applied to ascertain the unit root. For the sake of brevity only constant and time trend is
included in the estimated equation:

∆Y= a0+ γyt-1+ a1t+ et

Where: Y= series of variables in the demand for money equation (money variables M0, M1, M2). As
dependent, real GDP, inflation, interest on time deposit and financial innovations as independent
variables. However unit root and Co integration test for nominal variables were also performed. There
was no Co integration or unit root present in the nominal variables. The results of the above equation
are obtained in the Table 4:

Table 4: Unit Root test of various vectors in the money demand:

Vectors (ADF) γ1Partial Autocorrelation2

Real hard Money (M0) -1.600 -.122** 0.978

Real narrow Money (M1) -2.020 -.169* 0.931

Real broad money (M2) -3.520 -.320* 0.780

Real Gross Domestic Product -4.330 -.843* 0.157

Gross Total Investment -4.310 -.346* 0.654

Inflation -2.780 -.443* 0.557

Exchange rate -2.770 -.203* 0.897
Call Money rate -3.310 -.514* 0.486

1. Nelson and Plosser Unit Root test.

2. Partial Autocorrelation between Yt and Yt-1
(γ+1); Y already defined in the model 4
ADF: Augmented Dickey-Fuller test for Unit root (Critical value= -4.273*)
*: shows that coefficient is significantly different from zero at 0.01 probability level
**: show that coefficient is significantly different from zero at 0.05 probability level.

Table 4 revealed that there is no unit root as the ADF values are smaller than the critical values (p=0.01),
similarly γ coefficient significantly different from zero (p=0.01) showing stationary series (Nelson and

16
Plosser, 1982). As can be seen from Tables 1 through 3, the non- co integrating vectors for real money
M0, M1and M2, consist of real Gross Domestic Product, inflation rate and interest on time deposit and
financial innovation. Since the series are stationary having no Co integration, therefore ECM was not
applied here. The simple OLS method was applied to determine the parameters of the demand function
for money in Pakistan. A host of regression models were tested to determine the stable demand function
for money. The nominal variables of money, GDP, inflation, gross total investment, and exchange rate,
interest rate on advance and interest rate of saving were applied in various regression analyses. Stepwise
regression was also used to cull out non-significant variables. The independent variables were subjected
to tests showing no multi co linearity and/ orienteeroskadisticity.

Regression Analysis:
In the final analysis real money dependent variables (M0, M1and M2) were regressed against real GDP as
scale variable, inflation, interest on time deposit as opportunity cost of money demand and financial
innovation. The technology parameter as time was also used but was not significant. Therefore, the ratio
of M2/M1 was used as proxy for financial innovation. The regression results were obtained in Table 5.
The exchange rate was also tried as an opportunity cost for money demand but was not significant. All the
parameters have expected sign and were highly significant (p=0.05). Demand for real money, is sensitive
to real GDP, the coefficient of scale variable was higher in real M2 and the other parameters were also
having expected signs and significant (p=0.01) except lag coefficient of real money variables in all the
estimated demand equations There is no autocorrelation as indicated by the DW (>2) and R2was fairly
high in all the three regression models.

The financial innovation parameters were highly significant showing greater influence on the demand for
money in Pakistan. Of all the three models, real money (M2) model provides the robust results depicting
long-run stable demand for money in Pakistan. The results are consistent with the earlier studies in
Pakistan (Arize, 1994, Hussain, 1994). The magnitudes of the parameters were slightly at variance due to
the time period. The present study has longer time series than the earlier two studies. The long –run
elasticity of scale variables and interest rate are obtained in Table 6. The magnitudes of the long-run
elasticity’s for real GDP and interest was higher in real money (M2), indicating a better fit than the other
two models. Thus, broad money (M2) explains the best money demand function and the policy makers in
Pakistan must consider M2in designing monetary policy to control inflation. The role of financial
innovation (increased credit use, better balance of receipts and expenditure, reduced mail float, and
intensive use of money substitutes (Lieberman, 1977)) is important in explaining the demand for money.
This has also captured the effect of secular dollarization in period of high inflation that has taken place
due to monetary policy of the State Bank of Pakistan.

Table 5: Regression results relating Real Money Demand with selected variables in
Pakistan (1972-2005):

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 Model Variables Coefficients “t” Statistics R2 Durbin Watson
RM 0 (LN) Constant 10.661 4.169 0.97 2.019
(LN) (2.557)***
Real GDP 0.752 6.907
(LN) (0.109)
Inflation -.032 -3.950
(0.008) ***
Interest (Time -.060 -2.962
Deposit) (0.020) ***
Financial -13.532 -4.811
Innovation (LN) (2.813)
Lag RM0 (LN) 0.142
(0.113) 1.262
RM1 (LN) Constant 14.514 5.698 0.98 2.216
(LN) (2.547) ***
Real GDP (LN) 0.740 7.801
(0.095) ***
Inflation -0.035 -4.708
(0.007) ***
Interest (Time -0.079 -4.127
Deposit) (0.019) ***
Financial -16.289 -5.917
Innovation (LN) (2.739)
Lag RM1 (LN) 0.116 1.135
(0.102)
RM2 (LN) Constant 8.748 3.488 0.98 2.077
(LN) (2.508) ***
Real GDP 0.799
(LN) (0.114) *** 6.978
Inflation -0.037 -4.541
(0.008) ***
Interest (Time -.081 -3.811
Deposit) (.0.021) ***
Financial -11.169
Innovation (LN) (-2.708) *** -4.125
Lag RM2 (LN) 0.111 0.961
(0.116)
1. *** Indicates that the Coefficient is significantly different from zero at 0.01 probability level;
2. (): Indicates standard errors of the estimates;
3. Dependent variables are Real money demand (Reserve Money, M0), narrow money (M1)
and broad money (M2)
4. Financial Innovation: Log (M2/M1); and 5. Inflation and interest on time deposit are not in
log form; however dependent variables and real GDP are in log from
Table 6: Income and Interest Elasticity’s of Demand for money in demand:

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 Money Variables Income Elasticity Interest Elasticity

Real (M0) 0.752 -0.344

Real (M1) 0.740 -0.452

Real (M2) 0.779 -0.464

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Conclusion:

The lesson that the history of money supply teaches is that to ignore the magnitude of money supply
changes is to court monetary disorder. Time will tell whether the current monetary nirvana is enduring
and a challenge to that lesson. The paper tried to test whether they exists a stable long-run money demand
function for Pakistan which experienced high inflation during the analyzed period. The series were also
tested for Co integration and Unit root. Since test results did not show Co integration or unit root, ECM
was not used. The money demand function includes real money balances, real GDP, the rate of inflation,
interest rate on time deposits and/or the exchange rate and the financial innovation. The exchange rate
coefficient was not significant. The empirical results support the long-run stable demand function for
money in Pakistan. In all the three demand functions, broad money (M2) provided the robust estimates.
There was not a problem of autocorrelation. All variables in the money demand equation are individually
significant and signs are as expected. The Financial innovation sensitivity of money demand may indicate
better management of monetary policy. The long income elasticity was 0.78 which is consistent with
other estimates in Pakistan and elsewhere.

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