Money Demand
David has analysed money demand in many contexts, including narrow and broad money demand for both the UK and the USA. These analyses stimulated and were stimulated by interactions with various governmental bodies, and they resulted in significant press coverage as well.
David’s first money-demand study—Hendry and Mizon (1978)— responded to work on quarterly narrow money (M1) and broad money (M3) demand by Graham Hacche (1974), then at the Bank of England. In back-to- back publications in the Economic Journal, Courakis (1978) criticised Hacche (1974) for differencing data in order to achieve stationarity, and Hendry and Mizon (1978) proposed testing the restrictions imposed by differencing with Denis Sargan’s new common-factor test, later published as Sargan (1980). Additionally, Hendry and Mizon (1978) developed an equilibrium correction representation for quarterly M3, using the Bank’s data. The common-factor restriction in Hacche (1974) was rejected, and the equilibrium correction term in Hendry and Mizon’s (1978) model was significant.
Hendry and Mizon (1978) implicitly assumed that both the equilibrium correction term and the differences in their model would be stationary— despite no concept of cointegration—and that the significance of the equilibrium correction term was equivalent to rejecting the imposed common factor from differencing. Also, Hacche (1974) was specific to general in its approach, whereas Hendry and Mizon (1978) argued for general-to-specific modelling, which was also the natural way to test common-factor restrictions using Sargan's determinantal conditions. Sargan's COMFAC algorithm was already included in David's software program GIVE, with a Monte Carlo study of COMFAC appearing in Mizon and Hendry (1980).
A subsequent Bank of England study—of the monetary aggregate M1 by Richard Coghlan (1978)—considered general dynamic specifications, but they still lacked an equilibrium correction term.
In Hendry (1979), David responded by showing how narrow money acts as a buffer for agents' expenditures, but with target ratios for money relative to expenditure, deviations from which prompt adjustment. That target ratio depended on the opportunity costs of holding money relative to alternative financial assets and to goods, as measured by interest rates and inflation respectively.Hendry (1979) also highlighted problems confronting a simple-to-general approach, including the misinterpretation of earlier results in the modelling sequence, the impossibility of constructively interpreting test rejections, the many expansion paths faced, the unknown stopping point, the collapse of the strategy if later misspecifications are detected, and the poor properties that result from stopping at the first non-rejection. These criticisms dated back to Anderson (1962) at least, but many modellers seemed unaware of them at the time. Parameter nonconstancy was another key difficulty with earlier UK money-demand equations. The model in Hendry (1979), however, was empirically constant over a sample with considerable turbulence after the introduction of Competition and Credit Control regulations in 1971.
Hendry (1979) served as the starting point for subsequent papers on UK M1, including Hendry (1985), Hendry and Ericsson (1991b), Ericsson, Hendry and Tran (1994), and Doornik, Hendry and Nielsen (1998). Despite a very general initial model, that research obtained a simple specification with only four key variables, which measured the opportunity costs of money against goods and other assets, adjustment costs, and the money market's disequilibrium.
Stimulated in part by several extended visits to the USA, David turned to modelling US M1, with results published in Baba, Hendry and Starr (1992). As background, Goldfeld (1976) had recorded a supposed breakdown in US money demand in the early 1970s, so it was natural to implement models for US M1 similar to those that David had developed for UK M1.
Andrew Rose, who was David's MPhil student at Nuffield College in the early 1980s, showed how econometric methodology contributed to Goldfeld's results. Goldfeld had modelled money demand as a partial adjustment model and had imposed short-run price homogeneity. Both of those features are dynamic restrictions and were rejected on the data. Rose (1985) started with a more general dynamic specification without those restrictions, modelled from general to specific, and found a money-demand model that was empirically constant over Goldfeld's sample and for several years thereafter.However, even Rose's model showed parameter instability in the early 1980s. Many new financial instruments had been introduced, including money market mutual funds, CDs, and NOW and SuperNOW accounts. David hypothesised that these unaccounted-for financial innovations were the cause. Ross Starr also thought that long-term interest-rate volatility had changed the maturity structure of the bond market, especially when the Fed implemented its New Operating Procedures. Because high interest rates then became associated with high variances, a high long-term rate was no longer a signal to buy bonds: interest rates might go higher still and induce capital losses. This phenomenon suggested calculating a certainty-equivalent longterm interest rate—that is, the interest rate adjusted for risk.
Otherwise, David's approach to modelling US M1 was similar to his approach to modelling UK M1, with M1 being determined by the private sector, conditional on interest rates set by the central bank and the banking sector. The estimated long-run income elasticity for the USA was one half— consistent with the theory of transactions demand developed in Baumol (1952) and Tobin (1956), but contrasting with the estimated long-run elasticity of unity for the UK in Hendry (1979). That difference in elasticities could be explained by convenient and inexpensive overdraft facilities then available in the UK but not in the USA.
David's model of US M1 generated controversy. Seminar presentations at the Fed produced a number of challenges from the audience, including the claim that the Fed had engineered a monetary expansion for Richard Nixon's re-election. Dummy variables for that period were insignificant when added to David's model: agents were willing to hold that money at the prevailing interest rates, and confirming valid conditioning. The model was also criticised for its lag structure, which captured average adjustment speeds in a large and complex economy. Some economists still regard the final formulation as too complicated, perhaps believing in a world that is inherently simple. Other economists were concerned about data mining, although data mining per se would be hard-pressed to produce the large Z-values found, however many search paths were explored. The variables might proxy unmodelled effects, but their large Z-statistics would be highly unlikely to arise by chance alone.
Modelling annual UK broad money demand generated even more controversy for David. In 1982, Milton Friedman and Anna Schwartz published their book Monetary Trends in the United States and the United Kingdom; and it had many potential policy implications. Early the following year, the Bank of England asked David to evaluate the econometrics in Friedman and Schwartz’s volume for the Bank's Panel of Academic Consultants. Neil Ericsson was David’s research officer at the time, and their initial examination revealed much. Methodologically, Friedman and Schwartz’s approach was deliberately simple-to-general, commencing with bivariate regressions, generalising to trivariate regressions, etc. Testing their equations found considerable misspecification, including parameter nonconstancy, an anathema to money-demand equations. Also, Friedman and Schwartz had phase-averaged their annual data in an attempt to remove business cycles, but phase averaging still left highly autocorrelated, non- stationary series.
Because filtering (such as phase averaging) imposes dynamic restrictions, David and Neil analysed both the phase-average data and the original annual data. In late October, David presented the research in Hendry and Ericsson (1983) to the Bank’s Panel. Luminaries and rising stars in UK academia and government participated, including Chris Allsopp, Michael Artis, Andrew Bain, David Begg, Arthur Brown, Willem Buiter, Terry Burns, Ian Byatt, Alec Cairncross, Forrest Capie, Nicholas Dimsdale, Charles Goodhart, Jeroen Kremers, Rachel Lomax, R.C.O. Matthews, Ken Wallis, Geoffrey Wood, and David Worswick.It is helpful to put that meeting at the Bank in historical context. Monetarism was at its peak. Margaret Thatcher—then Prime Minister—had instituted a regime of monetary control, as she believed that money caused inflation, precisely the view put forward by Friedman and Schwartz (1982). From this perspective, a credible monetary tightening would rapidly reduce inflation because expectations were rational. In fact, inflation fell slowly in Britain, whereas unemployment leapt to levels not seen since the 1930s. The UK House of Commons’ Treasury and Civil Service Committee on Monetary Policy—which David had advised in Hendry (1981a, b)—had found no evidence that monetary expansion was the cause of the high inflation in the 1970s. If anything, inflation caused money, whereas money was almost an epiphenomenon. The structure of the British banking system made the Bank of England a “lender of first resort”, and so the Bank could only control the quantity of money by varying interest rates.
Shortly after the meeting of the Bank’s Panel of Academic Consultants, Hendry and Ericsson (1983) received considerable press coverage, starting with the British newspaper The Guardian and spilling over into other newspapers around the world. Chris Huhne—The Guardians economics editor at the time—had seen Hendry and Ericsson (1983), and he deemed the evidence therein central to the policy debate.
On 15 December 1983, The Guardian published two articles about Friedman and Schwartz (1982). On page 19 of the newspaper, Huhne had authored an article that summarised— in layman's terms—the critique by Hendry and Ericsson (1983) of Friedman and Schwartz (1982). David and Chris had discussed Hendry and Ericsson (1983) at length beforehand, and Chris's article—“Why Milton's monetarism is bunk”—provided an accurate statement of Hendry and Ericsson (1983) and its implications. In addition, The Guardian decided to run a front-page editorial on Friedman and Schwartz (1982) with the headline “Monetarism's guru ‘distorts his evidence'”. That headline summarised Huhne's view that it was unacceptable for Friedman and Schwartz to use their data-based dummy variable for 1921-1955 and still claim parameter constancy of their moneydemand equation. Rather, the statistical, numerical, and economic significance of that dummy variable actually implied nonconstancy, as Goodhart (1982) also discussed. Moreover, Hendry and Ericsson (1983) had shown that Friedman and Schwartz's money-demand equation was empirically nonconstant, even with their dummy variable. Nonconstancy undermined Friedman and Schwartz's policy conclusions. Chris later did a TV programme about the debate, spending a day at David's house filming.Hendry and Ericsson (1983) started a modelling sequence that included Longbottom and Holly (1985), Escribano (1985), and (after a prolonged editorial process) Hendry and Ericsson (1991a). Attfield, Demery and Duck (1995) subsequently claimed that the money-demand equation in Hendry and Ericsson (1991a) had broken down on data extended to the early 1990s, whereas Friedman and Schwartz's specification was constant. To compile a coherent statistical series over the extended sample period, Attfield, Demery and Duck (1995) had spliced several different money measures together, but they had not adjusted the corresponding measures of the opportunity cost. With that combination, the model in Hendry and Ericsson (1991a) did indeed fail. Ericsson, Hendry and Prestwich (1998) showed that that model remained constant over the whole sample with an appropriate measure of opportunity cost, whereas the model of Friedman and Schwartz failed. Escribano (2004) updated the equation from Hendry and Ericsson (1991a) through 2000 and confirmed its continued constancy.
Ericsson, Hendry and Hood (2016) subsequently examined the US moneydemand equations in Friedman and Schwartz (1982), finding substantial empirical shortcomings, even by Friedman's own criteria, such as subsample properties. Ericsson, Hendry and Hood (2016) highlighted difficulties with Friedman and Schwartz's simple-to-general methodology and showed that Friedman and Schwartz's final US money-demand equation had nonconstant parameters and that its residuals were heteroscedastic, even though that equation’s estimation included an adjustment for the heteroscedasticity induced by the phase averaging of the annual data. Furthermore, Friedman and Schwartz’s data adjustment for the USA’s increasing relative financial sophistication did not adequately capture the financial changes that occurred in the sample.
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