Identifying The Long-Run Relationship Of Real Money Demand, Real Income And Prime Interest Rates In South Africa

Abstract

This paper analyses the long-run demand for money in South Africa for the period 1971-2010. In particular, the paper estimates a co-integrated vector autoregression model of the long-run relationship between real money demand, real income and prime interest rate. A variety of theory consistent identification schemes, tests for co-integration, co-integration regression and error-correction-model (ECM) were applied in the order of the estimation approach developed by Johansen (1991). Preliminary data were also subjected to the autocorrelation function. Results show that the estimated elasticities indicate that a long-run equilibrium relationship exists between real money (M2), real income and the prime interest rate in South Africa. As expected, the coefficient of the equilibrium error term was found to be negative and significantly different from zero, implying that 0.227 of discrepancy between real money demand and its explanatory variables is eliminated in the following year. Evidence indicates that the retarded speed of adjustment for real money demand in South Africa needs about one year to re-adjust.