The Impact of Exchange Rate Uncertainty on the Demand for Money in Iran

Identification of factors affecting the money demand plays a very important role in the detection of monetary transmission mechanism; and knowing the elasticity of demand for money is vital to guide the monetary policy. The relationship between real money demand and its determinant factors has been at the center of a considerable amount of economic studies during the last decades. Exchange rate is one of the most important factors that has an important effect on many economic variables such as demand for Money. Apart from exchange rate, the variations in exchange rate that cause exchange rate uncertainty also can influence investor's expectations, the preferences of holding financial assets, and the money demand. With regard to the importance of exchange rate uncertainty and its impact on the demad for money, this paper aims to investigate the effects of exchange rate uncertainty on the money demand in Iran over the period of 1988(1) to 2008(4).
Theoretical Framework: The idea that money demand depends on the exchange rate in addition to income and interest rate was first proposed by Mundell (1963). During the last decades, subsequent studies tried to justify the relationship between exchange rate and money demand. Tower and Willett (1976), Al-khuri and Nsoul (1978), Holden, et al. (1979), Cuddington (1983), Bergstrand and Bundt (1990), Bahmani-Osooee and pourheydarian (1990), Leventakis (1993), Chaisrisawatsuk, et al. (2004), Arshad Khan, and Sajjid (2005), Azim, et al. (2010), and Shahadudheen (2011) emphasized on the role of the exchange rate on money demand. In addition to exchange rate, the variations in foreign exchange rate affect composition of optimal money holding. Changes in exchange rate have two effects on the money demand, i.e., wealth effects and substitution effects. Wealth holders ordinarily evaluate their asset in terms of domestic currency. Exchange rate depreciation, for example, would increase the value of their foreign assets held. To maintain a fixed share of their wealth invested in domestic assets, they will repatriate part of their foreign assets to domestic assets, including domestic currency. Hence, exchange rate depreciation would increase the demand for domestic money. On the other hand, exchange rate variations may cause a currency substitution effect, in which investor's expectation plays a crucial role. If wealth holders expect that the exchange rate is likely to fall further following an initial depreciation, they will respond by raising the share of foreign assets. In this condition exchange rate depreciation means higher opportunity cost of holding domestic money. Therefore, currency substitution can be used to hedge against such risk. In this regard, exchange rate depreciation would decrease the demand for domestic money (Sahadudheen, 2012).
In this study, money demand has been considered as a function of Gross Domestic Product (GDP) and inflation (to represent the economic activity and the opportunity cost of holding money respectively), real exchange rate and real exchange rate uncertainty. The data used in this study was gathered from central bank of Iran over the period of 1988(1)to 2008(4). To assess the relationship between the series, first, real exchange rate uncertainty was calculated by adopting a Generalized Autoregressive Conditional Heteroskedasticity (GARCH ) model and then was included in the money demand function along with other factors such as Gross Domestic Product, real exchange rate and inflation (as a proxy for interest rate). In the next step, with regards to nonstationary variables, cointegration test was performed to estimate the long run demand for money. Results indicated that there is long run relationship between variables in demand for money model function. Finally, the money demand function was estimated by means of Vector error correction Model (VECM).
In this study, we argued that since exchange rate and exchange rate uncertainty have both wealth and substitution effects, they could have a direct impact on the demand for money aside from other variables such as income and inflation. The estimation results from VEC model revealed that income elasticity of money demand (M2) was significant and positive; in the other words, the increase in Gross Domestic Product would increase the money demand. The effect of inflation on money demand was significant and negative. Inflation indicates that the cost of money holding and the increase in it would decrease demand for money. Real exchange rate and real exchange rate uncertainty have had negative and significant effects on money demand that indicates the substitution effect in Iran's economy. In fact, currency substitution effect has been overcomed by the wealth effects.
Conclusion & Suggestions: The negative effects of real exchange rate and its uncertainty on money demand indicates that movement and uncertainty of exchange rate decrease demand for money, which supports the substitution effect. In fact, with the probability of a considerable variation in exchange rate, the opportunity cost of holding money would increase and people prefer to substitute domestic money with foreign currency. For this reason, in order to avoid substantial fluctuations and stabilization of the exchange rate, the adoption of appropriate monetary and foreign exchange policies by the central bank is necessary for Iran's economy.