The Effect of Financial Innovation on Money Demand in Uganda: An Examination of New Payment Technologies on Demand for Narrow Money

Since the liberalization of Uganda's financial sector in the early 1990s, both foreign and local investors have been attracted to the sector. Competition and development, particularly technological development, resulted in the introduction of new payment technologies such as ATM cards, Electronic Funds Transfers (EFTs), Real Time Gross Settlement (RTGS), Internet Banking, the use of Visa and debit cards, and now mobile money transfers. These would ordinarily lead to either an increase or decrease in demand for money. Their effect on demand for money in Uganda has not been studied. In this regard, it is imperative to investigate the effect that these payment technologies have on demand for narrow money. In particular, this study assesses the effect of the number of automated teller machines (ATMs) and the volume of Electronic Funds Transfer (EFTs) on demand for narrow money (M1). Monthly aggregated data from June 2003 to March 2011 was used, and a Johansen-Juselius approach to cointegration was applied. In the long-run model, it is established that income has a positive effect on demand for narrow money. The opportunity cost variables of interest rate on the 90-day Treasury bill and expected inflation indicated a negative effect on demand for money. The Treasury bill rate, however, had a very small coefficient, suggesting that the interest rate channel is still a weak monetary transmission channel. Proxy variables for payment technology innovations, that is, ATMs and EFTs, have positive and significant effects on demand for M1. This emphasizes the need to take into account the effect of financial innovation in money demand estimation and when formulating monetary policies in the economy. The model was well specified based on the results from the Ramsey Reset test, and the CUSUM and CUSUMSQ did not reveal any sign of model instability. It is recommended that for sound monetary policies, the monetary authority should consider the effect of financial innovation on demand for money.