Too Much Money Is A Bad Thing: Controlling The Money Demand

Recent advancements in information technology and technical innovations in general have revolutionized trade and commerce and contributed to existing literature in the modern world. High-speed and low-cost data transfer that was made possible by information technology, created an excellent platform for e-commerce to grow rapidly. This modern business environment needs modern payment instruments. In other words, Paper-based method is no longer satisfying the need for fast and efficient transfer of funds and creates barrier for the trade. Therefore, electronic transfer of funds has been developed along with the development of e-commerce in various forms which is characterized by security, convenience, speed, low cost and high efficiency. Electronic transfer of funds can be done by automatic teller machines (ATMs) and electronic funds of transfer at the point-of-sale (POS) devices, and include electronic money (e-money), electronic cards (e-cards) and electronic check.

It is the payments mechanism of an economy that allows smooth functioning of its financial and real sectors. An efficient payments system is the one that offers real time settlement of financial transactions and facilitate the exchange of goods and services in a speedy, secure and reliable manner. Payment instruments are instruments/methods that individuals and firms use to pay for goods and services. It can also be used to transfer from one account to another. Banking models have developed at such an amazing speed that the traditional branch approaches used in the twentieth century is no match for it. World is now experiencing technological innovation, globalization, multinational corporations, and ever growing cross border trade. Therefore, the banks have to cope with this new environment by operating new models and platforms. These new platforms were made possible by technological advances that allow real-time processing of transactions. The operating models have progressed in line with the new needs and preferences of the customers.

Therefore, electronic transfer of funds has been developed along with the development of e-commerce in a variety of forms. Electronic payment method provides security, convenience, speed, low cost and high efficiency. The use of electronic money in a large scale has significant business, economic, political and social impacts.

The emphasis on cash as a major payment channel has been reduced significantly mainly due to introducing alternative payment systems in the last two decades which itself owes to the improvement in information and telecommunication technology. There have been intensive researches to investigate how emerging alternative payment systems have impacted the currency demand.

The function of the money demand is justifiably considered to be among the central behavioural relationships in macroeconomic theory. However, changes in the structure of the financial sector can dispassionately change the reliability of monetary aggregates measures, and therefore the efficiency of the monetary policy. It is due to the fact ignoring financial innovations is considered as a source of uncertainty that is injected to the economic environment in which central bank operates. Therefore, forecasting the money demand ignoring these innovations won’t be accurate.

The demand for money function creates a platform to investigate the effectiveness of monetary policies which is crucial for macroeconomic stability provided that this money demand is stable. Owoye and Onafowora (2007) point out that in order to control inflation rate, we need a stable money demand function. Baharomshah et al. (2009) state that if a steady and state relationship between money demand and its determinants (including financial innovation) exists, then the central bank will be able to use monetary policy to affect important macroeconomic variables successfully which in part plays a vital role in stimulating economic growth and stability.

Although financial innovation is not totally a new concept in economics but it gained speed since 1980s and it ended up in a hotly debated topic of the demand for money. The demand for money has always been one of the most popular subjects in applied econometrics and therefore it has attracted a large number of empirical studies. Since 1960s, Keynesians and Monetarists have been searching for a money demand that is stable and can be used to predict the future demand for money. Their debates about this topic have proved to be very controversial. The instability of the demand for money in the 1970s and in the 1980s led to introducing financial innovations. The importance of financial innovation kept growing in the 21st century as it has had serious implications for monetary policy.

Financial innovation is in the form of either technological advances which facilitate access to information, trading and means of payment, or new financial instruments and services and even in the form of more developed financial markets. Financial innovation makes it possible for agents to move their less liquid holdings to more liquid holdings thereby making a contractionary monetary policy (targeted at reducing excess liquidity) less effective. In other words, these financial innovations have the ability to undermine monetary policy thereby leading to instability in money market and the economy as a whole.

As a result of the growth in financial innovation over the last few years, several empirical studies have started including financial innovation in the money demand specification. Exclusion of financial innovation in the money demand function could lead to misspecification of the money demand through over estimation, commonly referred to as “missing money” (Arrau and De Gregorio, 1991). Empirical evidence suggests that financial innovation ought to be included in the money demand function to help solve some of the issues faced by money demand specification such as autocorrelated errors, persistent over prediction and implausible parameter estimates (Arrau et al, 1995). Understanding the relationship between money demand and its determinants has always been vital for monetary policy and therefore, has been a focal point for many researchers all over the world. A stable and predictable money demand is a requirement for monetary policy to be effective.

Cashless economy does not mean a total elimination of cash because money will still play a role in exchanging for goods and services for long in the future. In the new financial environment, there are alternative channels for making payments that reduces the use of physical cash to a minimum level. In other words, cashless economy means keeping the amount of cash-based transactions at a lowest possible level but not zero. In this system, transactions are not done in exchange for actual cash for the most part. The barter system (exchanging goods and services for goods and services) plays no role in this economic system. Buying and selling goods and services are done through electronic media in this environment. Basel Committee (1998) justifies the fact that the electronic money blends technological and economic characteristics. It is widely believed that electronic money is the backbone of the cashless economy. Electronic money is defined by the European Central Bank (1998) as an electronic store of money value on a technical device that is used for making payments and acts as a prepaid bearer instrument. Electronic payments contribute enormously to economic development of a country by providing convenience and safety and having great economic benefits.

Efficient electronic payments system help the economy to boost further by better-controlled consumer and business credit. According to Hord (2005), electronic payment is very convenient for the consumer, too. The customer only need to enter their credit card number and shipping address once as the information can be stored in a database on the retailer's Web server. Next time, they would simply login with their username and password and complete a transaction. Hord (2005) also points out that electronic payment reduces the cost of businesses by saving money that is spent on paper and postage. Improving customer retention is an added benefit of offering electronic payment. Regarding the fact that a customer’ information has already been entered and stored on the retailer's Web server, they are more likely to use this retailer for the conveniences involved (Hord, 2005). High-cash usage presents the following challenges: High cost of cash: The value chain from banks to corporations and traders that involves using cash bears a high cost; everyone is a loose due to the high costs associated with volume of cash handling. High risk of using cash: Robberies and other cash-related crimes are encouraged by carrying physical cash. If incidents like fire or flooding happen, cash can be lost which means a financial loss for those holding cash. Informal economy: High cash usage is an indication of the fact that a significant amount of money is circulation outside the formal economy. It acts as hindering the effectiveness of monetary policy that targets inflation and economic growth. Inefficiency and corruption: corruption, leakages and money laundering are all as a result of using cash on a wide basis.

In the context of these developments, new strategic evolved to promote business development and customer service in the banking industry. Early attempts of the banking services to incorporate new models for better satisfying these new commercial needs ended in failure as IT platform had not been developed enough. IT platforms are now advanced enough to allow for sophisticated software products and modules to operate enabling banks to cross-sell services, and better integrate and package these services. Previous bank products such as letters of credit in trade finance became automated thereby leading more satisfying customer relationship in line with customer needs (Julian Pogor, 2011).

Widespread publishing of electronic money has significant business, economic, political and social impacts. From the economic point of view, money supply, money demand, monetary policy and central bank are most affected by the diffusion of payment instruments that has serious consequences for capital, job opportunities and goods/services thereby creating new economy along with the development of money markets. Substitution of cash by electronic money and its influence on the demand for money is of great importance as fluctuations in money market will lead to fluctuations in other macro markets; and the effectiveness of monetary policy will be weakened, similar to the case of liquidity trap.

As we know, cash is the money that is published by the central bank; however, electronic money is not. It is actually internal money or demand deposit that is owed by the holder and is published not by central bunk but the money publisher. Therefore, on one hand, electronic money shrinks the central bank's income that comes from publishing banknotes and on the other hand, it leads to the increase of the money supply. Furthermore, electronic money has the potential to replace banknote and coin published by the central bank, thereby threatening the central bank's ability to exert its desired monetary policy, supervision, monitoring payments system, financial system stability and its independence. The final effect would be in the form of reducing the slope of the LM curve that in turn will decrease the efficiency and effectiveness of monetary policies. The demand for money will be decreased due to increasing the speed of money circulation, increasing supply, and greater diversity of goods whose money values are transferred by electronic payment instruments.

Introduction of new financial products due to innovations in the financial sector led to the increase of the efficiency of the financial sector than in turn caused the complication of the environment in which monetary policy operates. This situation makes money demand sensitive to changes in monetary environment and so researches should keep an eye on variables that may affect money demand. The implication of this finding for money demand is that financial innovation have to be included in the estimation of money demand, otherwise, the money demand function will be misspecified. There is a need for keeping an eye on the ever changing monetary aggregates that may cause structural changes in monetary developments. This is because, if financial innovations have impact on money demand, adjustment can be made to monetary aggregates in the presence of such monitoring. Although financial innovations increase efficiency of the financial sector, but it also complicates the environment in which monetary policy operates. Central banks need to conduct inflation targeting, economic growth enhancement along with enhancing efficiency and effectiveness in a changing financial and economic environment.

Generally speaking, improved overall efficiency of the payment system, and meaningful cost savings and efficiency to the entire economy is achieved by migrating from paper-based payments to electronic payments through improving productivity and lowering the cost of doing business which can generate a significant annual savings. To be more precise, by driving the displacement of cash and cheques through more intensive use of electronic payments, resources involved in manual processing can be redeployed and cost related to cash and cheque handling can be considerably reduced. The emergence of modern commerce and technological progress necessitates new means of payment that are more convenient, more expeditious, and more secure - qualities that are not effectively fulfilled by the traditional means of payment. Replacing paper cash by these instruments minimize crime, illegal drug trade, terrorism, illegal immigration, human trafficking and corruption, and transferring diseases. Benefits of new payment instruments include: For consumers: increased convenience, more service option, reduced risk of cash related crimes, cheaper access to banking services and access to credit. For corporations: Faster access to capital, reduced revenue leakage and reduced cash handling cost. For government: Increased tax collections, greater financial inclusions, increased economic development. For banks: reduced cost of operation (cash handling) and increased banks penetration. Other benefits include less cost of minting and transporting cash and more employment opportunity for financial sectors.

Governments, central banks, planning and development agencies and portfolio investors and other relevant stakeholders need reliable forecasts of macroeconomic variables such as demand for money to implement macroeconomic growth policies. Money aggregate M2 has a potential role in the conduct of monetary policy as an intermediate target (Amato and Swanson, 2001). However, dealing with non-stationary time series is a serious issue in econometrics. Cointegration (also referred to as a long-run equilibrium relationship) provides a solution to this problem by transforming the linear combination of non-stationary time series into a stationary one.

There are 3 different outcomes out of the bulk of the major previous studies about the impact of payment technologies (financial innovations in general) on the demand for money. The first category came to the conclusion that it has a negative effect on money demand while the second group conclude a positive impact and the third one produce mixed results or no significant impact.

First, we begin with Studies concluding negative effect. Baumol (1952) and Tobin (1956) state that payment technology (through reducing the transaction costs) has a negative effect on money demand. They rely on the trade-off between the liquidity benefit of retaining money (the ability to cope with the transactions) and the interest that is not gained in other assets. White (1976) concludes that credit cards significantly reduce the household demand deposits. Akhand and Milbourne (1986) come to the conclusion that credit cards allow agents to hold less in money balances and more in bonds than in the normal Baumol-Tobin model. Boeschoten (1992) find out that the use of ATMs, cheques and POS terminals significantly reduces cash holdings (based on microeconomic analysis of payment habits in the Netherlands). Duca and Whitesell (1995) arrive to this finding that expansion of credit cards has reduced demand for money in the United States (based on cross-sectional data on US households). Arrau et al (Arrau, De Gregorio, Reinhart, & Wickham, 1995) results that financial innovation in developing countries has a negative impact on the demand for money. Attanasio et al. (1998) sum up that the demand for money of households who holds an ATM card is much more elastic to interest rate than that of households who do not (based on time-series and cross-sectional data during 1989 – 1995 in Italy). Snellman, et al. (2001) conclude the expansion of using electronic payment instruments reduces the demand for money (based on panel data for 10 European countries during 1987-1996). Rinaldi (2001) states that the development of card payments (including ATM cards) will reduce the demand for money in Belgium. Drehmann et al. (2002) come up with the result that the number of POS terminals and ATMs has significantly negative effects on money demand (based on panels of European countries). Markose and Loke (2003) believe that high ATM density as well as low user costs may reduce cash demand. Stix (2004) comes to this idea that the people using the cards in their payments keep 18 percent less cash compared to those who have not used this card (based on Austrian micro data in 2003). Duca and Van Hoose (2004) show that money demand is inversely related to the improvements in transaction technology (such as ATM) that lower transaction costs. Yilmazkuday (2009) establishes this idea that credit and debit card usage has a negative effect on currency demand. The effect of debit cards is largely through withdrawals while that of credit cards occur largely through purchases. The usage of the debit cards has a larger impact on the currency demand than credit card usage. Columba (2009) come to the conclusion that technological innovation has a negative effect on currency in circulation, whereas their effect on M1 is positive. Hataiseree (2010) presents his finding with the results that a 10% increase in debit cards transactions would result in the reduction of demand for cash transactions of around 1.5% (based on quarterly data from 2005-2010 ).

Then we turn our attention to major studies with positive effect. Zilberfarb (1989) shows that the use of ATM reduces the transaction cost and therefore it increases demand deposits. Goodhart and Krueger (2001) state that people visit ATMs more often and withdraw small amounts of cash, which would increase the demand for small bank notes. Ramlall (2010) conclude that debit cards usage acts as complements rather than substitutes to notes in circulation (based on data from Mauritius for the period 1999 – 2008).

Finally, we arrive at studies with mixed or no significant effect as follow. Boeschoten (1989) shows that ATMs lead to reduced cash demand by the public but increased inventories of currency held by the banking sector for ATM usage. Thus the total effect of ATMs on the total amount of currency outstanding is quite moderate (based on Dutch data during 1990–1994). Snellman, Vesala and Humphrey (2001) proves that ATMs leads to more cash withdrawal but less amount of cash and therefore, the total effect on cash demand is ambiguous. Raa and Shestalova (2004) state that currency has a lower fixed cost and is preferred to debit cards for small value transactions, while debit cards, that bear a lower variable cost, are chosen for large value transactions. In other words, debit cards, has a positive impact on cash demand for small value transactions while it has a negative impact for on cash demand for large value transactions (based on Dutch data).

This study contributes to the relevant literature by estimating the Malaysian money demand including financial innovation. We use payment instrument (credit card, charge card, debit card, e-money) as financial variables.

The purpose of this paper can be summarized as follow: 1) to examine the empirical relationship between M2 real monetary aggregates, real income, real interest rate, real effective exchange rate and payment instruments using cointegration and non- cointegration models and specifically DOLS model as the selected model, 2) to compare dynamic forecast with static forecast, 3) comparing predictive power of the cointegration models with that of non-cointegration models, 4) to determine if non contegration model performs better in short-time horizon (say, 1-year) or in long-time horizon (say, 5-years) when it comes to forecasting, and 5) to do out-of-sample forecast based on the model with the best forecasting performance.

We did so by comparing static and dynamic forecasts for each model consisting payment instruments. The results indicated that for all of the structural based models, static forecast is superior to dynamic forecast (with the exception for ARDL model). Therefore, dynamic forecasts were ruled out and the comparison were made among static forecasts obtained from the models. Second, we compared the forecasting accuracy of dynamic forecasts of different models. Then, the chosen model was used for out-of-sample forecasting. Finally, we obtained and compared the estimated coefficients of the financial variables and their impact on money demand in Malaysia.

It seems from comparison graphs that cointegration/structural based models (DOLS, FMOLS, CCR, ARDL and VECM) do better in forecasting as compared to non- cointegration/structural based models (ARMA and Exponential Smoothing). However, the forecasting performance of these models are fairly good and comparable with structural based models for short time horizon forecasting but it gets deteriorated as we approach the end of the forecasting period meaning that non-structural based models do more accurate forecasting for a short time dimension than they does for long time dimension.

Our final chosen model (DOLS) has undergone serial correlation test to ensure robust and reliable results. Heteroskedasticity is not an issue for this estimator. Policy makers and central bankers may use these results in making appropriate policies for Malaysia that affects the economic growth and development of the country as it is the demand for money that is at the heart of ensuring stable prices and stimulating economic growth (thereby maintaining a stable macroeconomic environment) for any central bank.

We are not only interested in examining the effect of payment instruments on money demand but also in determining the effect of these instruments on the volatility of money demand using ARCH-type models. We determined that EGARCH is the best model for this purpose. Deriving short-run and long-run dynamics of the model was made possible by applying ARDL model and finally we applied VEC model to evaluate the contribution of each payment instruments to the fluctuations of money demand and determine the responsiveness of money demand to shocks to each of these instruments using variance decomposition analysis and impulse response function. By applying a second VEC model we attempted to examine if GDP acts a channel to transmit the effect of payment instruments to money demand.