Money demand stability: New evidence from transfer entropy

This paper revisits the empirical relationship between interest rates and money demand from a novel perspective, i.e., information theory. Particularly, we utilize the model-free transfer entropy to quantify the flow of information from interest rates to monetary aggregates and present three findings. First, we document a hump-shaped informational link between interest rate and M1 monetary aggregate, with a rounded high point in the late 1980s and early 1990s. Second, we identify three structural shifts in the information transmission from interest rate to M1. The first two breakpoints occurred in the early 1980s and mid-1990s, likely as a response to the removal of Regulation Q and the introduction of sweep technology, respectively. The third shift took place during the relatively less-explored period of the early 2000s. Finally, we unravel a previously unreported pivotal distinction between the first two changepoints despite the apparent similarity in inducing money demand instability: the 1980s financial deregulations facilitate the transmission of information, whereas the 1990s financial reforms acted as an impediment to the information flow. Our results are robust to alternative entropy measures.