Money Demand in the Czech Republic since Transition

Since the break up of the Czech-Slovak Federation on 31 December 1992, the Czech Republic has been at the forefront of the transition to a market economy. Key aims of the Czech Republic, and many other former centrally planned economies (FCPE), is low inflation and a stable exchange rate, particularly for those who ultimately wish to enter the European Union (EU). Similar to the US Federal Reserve and the European Central Bank (ECB), the Czech National Bank (CNB) adopts some form monetary targeting to control domestic inflation. One of the key elements (along with other economic indicators) is a stable demand for money function, which may include real household income, interest rates, and inflation. We use three measures of money in the money demand estimation, currency in circulation (=M0), M0 plus demand deposits (=M1), and M1 plus quasi money (=M2). We also specifically focus on investigating the extent of currency substitution in the Czech Republic. Given the nature of a transitional economy and following some recent evidence for transition economies, we included a proxy for currency substitution. We take the ‘ conventional ‘ domestic money demand equation and augment it with the return from holding foreign bonds - this is often referred to as the ‘portfolio balance effect‘. We also include the expected change in the exchange rate which is referred to as currency substitution. We define the foreign country to be either the US or Germany. Given the nature of a transitional economy, the gradual openness of the market and the developments in financial markets we would expect currency substitution to be significant. A finding of currency substitution would point to a lack of credibility of programs to control inflation as foreign money is used as a method of transactions and a store of value. The data set consists of monthly series, over the years 1992-1997. The required data are taken from the CNB, Financial Statistics Report and Datastream. Even faced with a limited data set we do consistently find that a long-run relationship exists between real money balances (M0, M1 and M2), a measure of real income and inflation, with the coefficients having the expected sign. An important variant on the standard domestic model is the investigation of currency substitution. Both graphical and empirical results suggest that any currency substitution was a one-off event due to increased uncertainty at the end of 1992 at the time of monetary dissolution. Certainly currency substitution in the Czech Republic is not as strong as has been found in other former centrally planned economies. This may be due to the gradual reform taken by the Czech authorities, the stable rates of inflation and the relatively stable exchange rate (and volatility of the exchange rate) established after 1993 which provides less incentive in currency substitution.