Stability of Money Demand and Monetary Policy in Papua New Guinea (PNG): An Error Correction Model Analysis

Abstract

An error correction model (ECM) is used to study the Properties of money demand and to evaluate the appropriate monetary policy in PNG. The study confirms that the determinats of money demand are real GDP, nominal interest and inflation rate. The income elasticity of money demand is very low. The demand for money in PNG was stable during 1979-95, suggesting that the monetary targeting regime by the PNG Central Bank is feasible. However, as PNG proceeds with economic reforms that Includes financial sector reform and a floating exchange rate regime, the stability of the demand for money may have to be re-examined periodically. The best approach for conducting the monetary policy in PNG is to target the inflation rate. [E41, E52, C22]

Some empirical evidence on the demand for money in the Pacific Island countries

“…In this paper, we have briefly surveyed previous works on the demand for money in the PICs. It may be argued that the studies prior to Rao and Singh (2005) that is Katafono (2001), Kannapiran (2001) and Jayaraman and Ward (2003) have limitations in their specification and therefore their long‐run income and rate of interest elasticities are either over‐estimated or under‐estimated. This paper makes contribution to the literature by estimating the money demand functions using the newest time series techniques for a group of PICs over the period 1974‐2004.…”

“…Empirical studies on demand for money in the PICs are only a handful and available only for FJ, PNG, SAM and Tonga. These studies are Katafono (2001), Kannapiran (2001), Jayaraman and Ward (2003), Rao and Singh (2005, 2006), Rao and Kumar (2007), Kumar and Manoka (2008) and Singh and Kumar (2009). Though these studies do find some evidence of long‐run relationship of money demand, some of them seem to have limitations either in their specification or empirical findings.…”

“…For PNG, Kannapiran (2001) utilized annual data from 1979 to 1995 and the Engle‐Granger method to estimate the demand for M2 in PNG. He obtained an implausibly low income elasticity of 0.20.…”

“…Limitations in the data have resulted in only a limited number of empirical studies that investigated the long‐run relationship of money demand in the PICs. For instance, see Katafono (2001), Kannapiran (2001), Jayaraman and Ward (2003), Rao and Singh (2005, 2006), Rao and Kumar (2007), Kumar and Manoka (2008) and Singh and Kumar (2009). The correct specification of both long‐ and short‐run demand for money functions is important.…”