The relationship between money demand and interest rates: an empirical investigation in Sri Lanka

Abstract

Introduction:

The interest elasticity of the demand for money is an important indicator in considering an effective anti-inflationary monetary policy (Hossain and Younus, 2007). Identifying the empirical relationship between money demand and interest rates is important in effective formulation of monetary policy in Sri Lanka. The relationship between money demand and interest rates has been explained by various theories including classical quantity theory approach, Cambridge approach, Keynes’s liquidity preference theory, Baumol-Tobin money demand theory and Friedman’s modern quantity theory of money. In liquidity preference theory, Keynes postulated that there are three motives behind the demand for money: the transactions motive, the precautionary motive, and the speculative motive. Baumol (1952) and Tobin (1956) independently developed similar models for demand for money, which demonstrated that even money balances held for transactions purposes are sensitive to the level of interest rates. As interest rates increase, the amount of cash held for transaction purposes will decline, which in turn means that velocity will increase as interest rates.

A few studies for money demand relations have been done for Sri Lanka since 1990 (Wijewardena, 1985). However most of these studies explain fiscal and monetary policy issues and behavior of interest rates. There is a dearth of empirical studies which examined the relationship between money demand and interest rates using Baumol- Tobin Model for Sri Lanka. Some studies examined the relationship between money demand and interest rates using Keynesian theory.