The Role of Definition of Money in the Stability of the Iranian Demand for Money

Demand for money and its stability are important in an economy especially in the design of monetary policy. Money consists of different components and its definition would depend on types of components included. It has been argued that the simple sum indices as the definition of money are inconsistent with microeconomic theory. By using the simple sum method for aggregation, it is implicitly assumed that there is a perfect substitution among the various money components. An alternative definition of money uses the index number theory to construct indices which allow different substitution rates among the components of money. In this paper, we estimate the Iranian demand for money for the period 1367:1 to 1383:1 (1988-2004) using Divisia index for definition of money. The results show that the estimated demand for money in Iran is stable. However, the adjustment rate in the models using Divisia index is higher than that when the simple sum index is used. Our results are consistent with the other studies that indicate a rapid adjustment in the Iranian money market.