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Currency Substitution And Stability Of Money Demand In Ghana

George Tweneboah () and Paul Alagidede ()

Journal of Developing Areas, 2018, vol. 52, issue 2, 41-53

Abstract: Monetary policymakers and economists in Ghana have become very disconcerted about the policy implications of the widespread demand for and gradual shift to the use of foreign currency in the economy in recent years. The question of whether the mounting trend of dollarization provides evidence of currency substitution has remained an empirical quest. The purpose is to empirically establish whether the data provides evidence of currency substitution. The method employed models a long-run money demand function within the portfolio balance framework, which distinguishes between capital mobility and currency substitution and also accounts for the pre and post inflation targeting monetary policy regime. The estimation technique follows the cointegration and error correction framework using the Autoregressive Distributed Lag model for annual data from 1960–2013. The variables used are real money balances (defined in both narrow and broad terms) and real income, domestic interest rates, foreign interest rates, and exchange rates. The study reports that there is a stable long-run relationship between real money balances and the determinants. The results highlight that the income elasticity for narrow money is close to one but less than unity for broad money. The coefficient of the interest rate variable is negative for narrow money but positive for broad money pointing out differences in the definition of the two categories of money. Also, whereas the coefficient for returns on foreign bonds is negative for both narrow and broad monetary aggregates, the exchange rate variable remains positive throughout. The findings reveal that, although there is no empirical evidence to support currency substitution, exchange rates and foreign interest rates are significant factors in the domestic money demand dynamics. The validity of foreign interest rate and/or the expected depreciation of the domestic currency in the long-run money demand equation capture the existence of capital mobility. The implication is that domestic agents use foreign currencies together with the domestic currency, although the domestic currency remains the legal tender for domestic transactions. The results underscore the importance of developments in foreign interest rates and exchange rates for fiscal, monetary, and exchange rate policies in Ghana. The policy implications of these findings have been deliberated to provide a guide for policy choices in the emerging economy.

Keywords: Currency substitution; capital mobility; money demand function; portfolio balance approach; cointegration; Ghana (search for similar items in EconPapers)
JEL-codes: C22 E41 E52 E58 (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:jda:journl:vol.52:year:2018:issue2:pp:41-53