Nonlinear Assessment of Money Demand Function and Estimating Threshold Level of Inflation in Iran, 1973-2011

This study examines the linearity of money demand function and monitors money demand reaction with respect to different levels of inflation. The linkage between money demand and inflation is not always straightforward: some research report is positive but it is revealed negative in some other papers. It has been argued by economists that such conflicting results has roots in the differences associated with the structures of economic agent’s expectations. Therefore، this paper tries to shed more light on this problem as well as monitoring the behavior of Iran''s money demand function encountering to different levels of inflation on one hand and computing threshold level of inflation on the other hand using annual data from 1973-2011. For this purpose، four money demand functions are developed in terms of Keynesian school and Friedman theory of money demand with nonlinear specifications، which are estimated using smooth transition (STR) system. First، stationarity of time series has been examined with unit root tests and then existence of a long-run co-movement among the variables have been verified by Johansen co integration procedure. Furthermore، in order to distinct long-run from short-run dynamics، a vector error correction (VECM) procedure has been adopted. Findings are in favor of existence of a nonlinear money demand function in Iran and a well-adjustment of logistic smooth transition function (LSTR) in this case. Results show that threshold level of inflation is about 14. 75%، indicating that the money demand function reacts negatively facing any higher level of the estimated threshold level of inflation، but positively in lower rates.