Financial Innovation and the Speed of Adjustment of Money Demand: Evidence from Bolivia, Israel, and Venezuela

B ofGovernorsoftheFederalReserveSystem InternationalFinanceDiscussionPapers Number567 October1996 FINANCIALINNOVATIONANDTHE SPEEDOF ADJUSTMENTOF MONEYDEMAND: EVIDENCEFROMBOLIVIA,ISRAEL,ANDVENEZUELA MartinaCopelman NOTE: InternationalFinanceDiscussionPapersarepreliminarymaterialscirculatedto stimulate discussionandcriticalcomment. Referencesinpublicationsto InternationalFinanceDiscussion Papers(otherthanan acknowledgmentthatthewriterhashadaccessto unpublishedmaterial)should beclearedwiththeauthoror authors.

BSTRACT Traditionalstudiesofmoneydemandfor bothdevelopedandlessdevelopedcountrieshave shownthatthereare periodsof “missingmoney,”thatis, thereisconsistentoverpredictionof real balances. Thispaperusescointegrationtechniquesto studytheeffectsof financialinnovationonthe demandfor realbalancesinBolivia,Israel, andVenezuela. Theresultsshowthatfinancialinnovation canaccountfor theinstabilityofmoneydemandobservedinthesecountries. In particular,I findthat thelongrundemandfor realbalancesshifieddown. In addition,I showthatthespeedat which peopleadjusttheirdemandformoneywhenoutofequilibriumincreasesfollowingfinancial imovation.

FinancialImovationAndTheSpeedofAdjustmentofMoneyDemand: EvidenceFromBolivia,Israel, AndVenezuela. MartinaCopelmani 1.INT’RODUCIOTN Empiricalstudiesofthedemandformoneyhaveflourishedinrecentyears. Thereasonforthis largevolumeofliteraturecanbeexplainedbytheimportanceofmoneydemandinmonetarypolicy. The incomeandinterestelasticitiesofmoneydemandareatthecoreofthemostbasicmacroeconomicmodels suchastheIS-LM;wheretheeffectivenessofmonetarypolicy(thatis, itsabilityto affecttherealside of the economy)dependson the elasticityof moneydemand. It is very importanttherefore, to find consistentestimatesoftheseelasticities. Followingthe seminalpapers by Goldfeld(1973,1976)a large number of papers for both developedandlessdevelopedcountrieshaveshownthattherehavebeenperiodsof“missingmoney”that is, there is consistentoverpredictionof real balances. Thishas led to the conclusionthatthemoney demandfunctionisbasicallyunstable. Twoprincipalexplanationshavebeenusedtoaccountforthisinstabilityofmoneydemand.One isfinancialimovationandtheotheriscurrencysubstitution.Throughoutthe 1980’schangesinfinancial markets have been very widespread, and have been particularly importantin Bolivia, Israel, and Venezuela. Allthreeofthesecountriessufferedhighinflationsduringthe 1980’s;twoofthem,Bolivia and Israel, were actuallyhyperinflations. In the mid to late 1980’sBolivia,Israel, and Venezuela ‘ TheauthorisstaffeconomistintheDivisionofInternationalFinance,BoardofGovernorsofthe FederalReserveSystem. Theviewsexpressedinthispaperare solelytheresponsibilityoftheauthor andshouldnotbeinterpretedasreflectingthoseoftheBoardofGovernorsoftheFederalReserveSystem or otherMembersof its staff. I am gratefulto RudigerDornbusch,StanleyFischer, DavidHendry, RobertSolow,AlejandroWerner, and the participantsof the M.I.T. InternationalBreakfastand the MoneyLunchaswellastheparticipantsoftheseminarsattheFederalReserveBoardandtheXIILatin AmericanEconometricSocietyMeetingsforhelpfil commentsandsuggestions.

embarkedon stabilizationprogramsdesignedtohaltinflation. The purpose of this study is to show that financialinnovationleads to a faster speed of adjustmentofmoneydemandtoitsdeterminants,aswellastotheinstabilityoftheobserveddemandfor real balances. This is an aspectof the moneydemandliteraturewhichhas hardly been explored,in particularin termsof thenewcointegrationmethods. For Israel, Melnick(1991)showsthatignoring financialinnovationistheprincipalcauseforthelackofstabilityinthemoneydemandequation. I will showthatthelongrundemandforrealbalancesnotonlyshifieddown,butthatintheshortruntheeffect of financialimovation has-been to increasethe speed with whichpeopleadjusttheir actual money holdingsto theirdesiredmoneyholdings. EngleandGranger(1987)haveshownthatusingthetraditionalmethodofpartialadjustmentto estimatethedemandformoneymayleadtomisspecificationandincorrectconclusions. Itis important to takeaccountofthefactthatthevariablesusedintheestimationarenonstationary,somethingthatis usuallyignored. Ignoringthestochasticpropertiesofrealmoneybalances,thetransactionsvariable,and theopportunitycostvariablecanleadto OLSregressionresultswhicharestatisticallyinvalid. For this reason,Iwillusewhathasbecomethestandardcointegrationapproachtoestimatethedemandformoney for Bolivia,Israel, andVenezuela. The remainderof the paper is structuredas follows. Section11presents the model which providesthe theoreticalfoundationsfor the empiricalsection. I use the Miller-Orr(1966)modelof moneydemandandshowthatadeclineinthetransactionscost(whichisaproxyforfinancialimovation), leadstoafasteradjustmentofmoneydemandtoitsdeterminants.Section111providesabriefdescription oftheevents inBolivia, Israel, andVenezuela. Section IV presentsthecointegration methodology. In SectionVIestimatethelongrundemandformoneyinallthreecountriesusingthecointegrationmethods oftheprevioussection. In thissectionI alsotestfor thestabilityof thedemandfor realbalancesand ,.allowforbothaonetimeshiftandachangeintheslope. InSectionVItheshortrundemandformoney is estimatedas an error correctionmodelandthechangein the speedof adjustmentis demonstrated. 2

SectionVIIconcludes. SECTIONII. THE MODEL Thelongrunmoneydemandfunctionis representedintermsoftheMiller-Orr(1966)model. Themodelisa transactionsdemandformoneywherethedecisionmakercanholdtwotypesofassets, 1)moneywhichdoesnotearnanyinterestand2)a “bond”or otherearningassetwhichpaysinterestat a rateiperdollarperday. In whatfollowsI willusetheinflationrate, Zt, astherelevantopportunity cost,sinceinallthethreecountriesinthestudyinterestrateswerefixedfora largepartofthesample, Thefirmfacesa stochasticcashflowthatcanbecharacterizedbya sequenceoft independent Bernoullitrialsper day. In eachtrialcashbalancescangoupby x withprobabilityp or cangodown byxwithprobabilityq= l-p; wherex isthe “stepsize.” Transfersoffundsbetweenthetwoassetscan bemadeinstantlyatcostb. Thisisacostwhichisincurredpertransactionandisindependentofthesize ofthetransaction. A reductioninb decreasesthecostoftransactionsandtherefore,I willassociateit with financialimovation as in previousstudies. Finally,the minimumlevel of moneyholdingsis normalizedto zero. ThetimepathofcashholdingswillevolveasinFigure1,whereh isthemaximumholdingsof cashthattheindividualwilleverhave,andz istheleveltowhichbalancesarerestoredafteratransfer. Theoptimaldesiredlevelofcashholdingscanbederivedbyminimizingthetotalexpecteddailycostof thisSspolicygiventhetwoparametersh andz.” Thesolutionto thisproblemisan optimallevelof cashholdingsgivenby h“ +=” .4 3b m,”= ~ [~ ~’~1’” (1) 3 where See MillerandOrr (1966)pages420-423forthemethodologyandderivationofequations(1)and (2). 3

i ,’ h .z o 4

~*=~3 b X2 t1,,3 , ~*=3Z* (2) 4n andwhere~“ denotestheoptimaldesiredstockofrealmoneybalancesandZtistheinflationratewhich is a proxy for the opportunitycost. Equation(2) givesthe optimalupperboundas a functionof the optimalreturnpoint. Withthisequationfortheoptimallevelofcashbalancesinmind,wenowproceed todeterminetheeffectsoffinancialinnovationonboththespeedofadjustmentandthelevelofoptimal moneyholdings. Inthiscontext,financialinnovationisproxiedasadeclineinthetransactionscosts,b. Alower transactionscostimpliesa lowerrealcostoftransformingfinancialassetsintomoney. Holdingallelse constant,thisimpliesthatfinancialinnovationinducesa reductioninthedesiredquantityofrealmoney balancesthat are held. One can actuallythink of b as also includingeffects associatedwith the introductionof more instrumentsat thetimeof thefinancialliberalizationwhichcan beusedto avoid holdingmorecashbalances. Equation(2)showsthatareductioninbwilldecreaseh*andz*,narrowingthebandofinaction of Figure 1;whileequation(1)showsthatm*alsodeclines. The idea is thatwhentransactionscosts decline,anindividualwillwaitlesstimetoadjusttheirmoneybalanceswhentheyareoutofequilibrium. Therefore,asagentsadjustsoonerthanbefore,thespeedofadjustmentofdesiredmoneyholdingsinthe economyas a wholeincreases. Next,wetakeabrieflookatthefinancialliberalizationepisodesthattookplaceineachcountry. SECTION1I1. A LooK ATBOLIVIA.ISRAEL.AND VENEz~ 111.1BOLIVIA During1984-1985,BoliviaexperiencedthehighestinflationrateofLatinAmericaandoneof 5

thehighestinworldhistory. UsingCagan’s(1959)definitionofahyperinflation,thatis50%amonth or higher, Sachs(1986)placesBolivia’shyperinflationas theseventhhighestofthetwentiethcentury. Duringapproximatelytheyearandahalfwhichthehyperinflationlasted,theaveragemonthlyinflation ., ratereached46%. Inresponsetothis,theBoliviangovernmentintroducedastabilizationprograminlate Augustof 1985. Thehyperinflationquicklysubsidedandoverthepastfewyearshasremainedbothlow and fairlystable. Thisprogramwas introducedin conjunctionwith an extensiveliberalizationof all markets,andfinancialmarketsinparticular. - Morales(1988)describesthevastfinancialliberalizationwhichwasintroducedinBolivia. All interestrateceilingswereeliminatedandcapitalmarketrestrictionswerealsoeliminated. Bankswere allowedtooperateininternationaltradeandcapitalaccounttransactionswithoutrestrictions.Inaddition, depositorswereallowedtoopendollaranddollarindexedaccountsandbankscouldmakeloansindollars orindexedtothedollaraswellasanylocalcurrencyloantheydeemedvaluable. Thesedollaraccounts havelowerreserverequirementsthanotheraccounts. The effect of this financialliberalizationwas to expandthe definitionof M2, of whichthe depositsin dollarsweretheprincipalcomponent. Shorttermdollardepositsandthoseindexedto the dollarincreaseddramatically,fromlessthan$28millioninSeptemberof 1985to$270millioninMarch of 1987. Thelargeshiftinpeople’sportfolioswasmostlydueto theveryhighinterestratesthatwere . observedduringthis time, not only in pesos, but in dollarsas well. Interestrates reached32% in September1985andremainedhighforsometime. Table1showsthatdollardepositsreachedabout78% oftotalcommercialbankdepositsin 1989,upfromlessthan30%priortothederegulation.Evenafter thehyperinflationended,thedemandforrealbalancesneverreturnedtoitspreviouslevel(seeFigure2), whichisfirther evidenceforthehypothesisthatfinancialimovationcausedthedeclineinrealbalances. 6

TABLE 1.BOLIVIA: Dollarized Deposits and Interest Rates 1986 1987 1988 1989 l.DollarizedDeposits 45.5 67.5 73.4 78.0 (%oftotalcommercibaalnkdep.) . 2. InterestRates 14.3 15.6 15.5 14.7 annuanlominarlatefordollarizeddep. source: Morales(1991) BOLIVIA:INFLATIONAND REALMl 200 2500 150 v -. t I N t It I I II #l It I I I /, I1;, I // * 50 * 0 I I I Ir 1 I I: 80 81 82 83 84 ’85 “86 ’87 ’88 ’89 ’90 ’91 l— Inflation ----- ml I . FIGURE2A 7

FIGURE2B BOLIVIA: REAL Ml TO GDP RATIO 0.08 0.07 0.06 0.04 0.03 0.02 i 8 I 0 I I 8 I I 1 I I 8 1 1 2 I I 8 I I 3 I I 8 1 I 4 I I 8 I I 5 I I 8 I I 6 I I 8 I I 7 I ’ I 8 1 1 8 I I 8 I 9 I I I 9 I i 0 I I 9 I I 1 TIME 111.2ISRAEL In July of 1985,Israel introduceda stabilizationprogramwhichwasextremelysuccessfulin endingthehyperinflation. UnliketheBoliviancase,Israeldidnotimmediatelyadoptallcapitalmarket reforms. The drop in real balancesexperiencedby Israel occurred in the beginningof 1987 in

conjunctionwiththeadoptionof severallargeandimportantfinancialmarketreforms.11 PreviousstudiesofmoneydemandinIsrael( seeforexampleMelnick(1991)andBen-Bassat and Marom (1988))have found a shifi in the demand for real balances after the 1976 financial liberalization,however,moststudieshavenotlookedattheperiodafter 1983. Figure3showsthatreal balancesinthelate 1980’swerelowerthanintheearly 1970’s,eventhoughinflationwasdownto the samelevelsandGDP washigher. During the last quarter of 1986, Israel began a process of financialliberalization. The liberalizationhas takenthe formof a unificationanda reductionof mandatoryliquidityratios. Most importantly,inAprilof 1987nonfinancialfirmsweregivenfullfreedomto issuebonds. In addition, limitationsonforeign-exchangelinkedcreditwererelaxed. Inessence,thegovernment’sroleinfinancial marketswasseverelyreduced(Ben-Bassat1988). ThisIedtoa narrowingof interestrategapsin the capitalmarketandadecreaseintheaverage rateon governmentbonds. Sincethederegulationandthe stabilizationprogram,newfinancialinstrumentshavebeena bigpart ofIsrael’smoneymarket,which haveledto thedeclineindesiredmoneyholdings. llInmid 1985,therewasa changeintheregulationsdesignedto actuallyincreasemoneydemand, however,itwasnotsuccesfulas canbe seeninFigure3 anddocumentedinBen-Bassat(1988). 9

I FIGURE3A ISRAEL: INFLATION AND REAL BALANCES 0.6 60 , I*II ***,4 , 0.5 I 9- I I 50 I I lt t ** \. 8 l 0.4 40 0.3 30 I I f I .’l * 0.2 20 I t * # I I I 0.1 10 0.0 0 \ 7 ll[ll 0 llllllIiiIiiIll 72 74 1,11, 7 ,1,, 6 ,[,,11,,,11,, 78 80 [,11][,,,,,,, 8 ,,,,,, 2 ,,, 84 86 ,,,,,, 8 I 8 1I1“’1’f 90 —INFLATION ----- Ml ... 10

FIGURE3B ISRAEL: REAL Ml TO GDP RATIO 0.40 0.35 0.30 0.25 & 5 0.20 E A 0.15 0.10 0.05 0.00 7 >11 0 1, ,1[, 72 ,, [,,,111 74 ,1, ,,, 7 ,1, 6 ,,,,,,,,,, 78 ,,, 8 ,,, 0 ,,, , ’8 I I 2 I l’” ’8 II 4 Il’” ’8 II 6 i 11” ’8 I1 8 1 ’ 1II ‘ I g f o TIME 111.3VENEZUELA In1989Venezuelaexperiencedasharpdropinrealmoneyl)alancesthatcannotbeaccounted forwiththetraclitionasletofexplanatoryvaria?)les.Figure4 shoWsrealmoneybalancesanciinflation duringthisperiod.Thedropinmoneydernandcoincideswiththebeginningofafinancialliberalization packageintroducedin1989alongwiththestabilizationprogramwhichfloatedtheexchangerateand removedallcapitalrestrictionsandaccesstotheforeignexchangemarket. 11

i FIGURE4A VENEZUELA: INFLATION AND REAL Ml 35 100000 30 ; 90000 II II II l- It . 25 80000 ~ 20 70000 15 60000 ~ 10 50000 .’ 5 40000 0 30000 % I 1 1’1 1 1“’1’’’1’’’1’”1 “’1’ ’’1’ ’’1 ’’’1” ‘1’’ ’1 ’’’1” 78 79 80 81 82 83 84 85 86 87 88 89 90 91 l— inflation ..--- Mll

FIGURE4B VENEZUELA: REAL Ml TO GDP RATIO 0.9 0.8 0.7 ~ 0.6 u R 0.5 0.4 0.3 ? I 1 1’ I I 1“’1’’’11’’1’”1’ “11’’1’’’1’’’1’”1 “’l”f 78 79 80 81 82 83 84 85 86 87 88 89 90 TIME Restrictionson nominalinterestrates were lifted,newtypesof financialinstrumentssuchas savingsandtimedepositaccounts,andnewCentralBankbondscalled“BonosZeroCoupon”(orzerocouponbonds)wereintroduced.Thelatteraccountedfor55.7%,in1990,0ftotalflows inthegross flow of transactionsinthe stockmarket. In addition,the reserve requirementsfor demanddepositswere unifiedandtheroleoftheCentralBankasa lenderoflastresortwasfirmlyestablished. Thesereformsledto nominalinterestratesof around30%and to a strongdecompositionof portfoliosby agentsin favorof highlyliquidassetswithvery highreturns, suchas timedepositsand savingscertificates. In 1990alone, time depositsand savingsaccountsincreasedat a real rate of 13

approximately119%. (See the CountryProfilefor Venezuela) This feature of the financialmarket refo~s isnotexclusiveto Venezuela. Allthreecountriesintroducedawiderangeofnewinstruments withwhichpeoplecouldsaveonmoneyholdings. Thesenewinstrumentscreateirreversibilityeffects on the demandfor money (Piterman(1988)). This is one of the channelsthroughwhich financial imovationhaspermanenteffectsonmoneydemand. Havinglookedat the financialimovationepisodesin the three countries,I now turn to the estimationofthelongrunandshortrunmoney-demandforeachcountry, In thenextsection,I briefly discussthecointegrationapproachto beusedintheestimations. SECTIONIV,THE COINTEGRATIONNAPPROACH Traditionalestimationsof money demandhave a partial adjustmentspecificationwhich is estimatedby OLSsuchas: (3) ConventionalOLSanalysisassumesthattheerrorisnotseriallycorrelatedandisnotcorrelatedwiththe regressors. Moreimportantly,itassumesthatalltheregressorsareeitherdeterministicrandomvariables or stationary. These assumptionsgive consistentOLS estimatesand allow the use of t-statisticsto determinethesignificanceofdifferentcoefficients. - Aproblemarises,however,whentheregressorsare generatedby a nonstationaryprocess. In thiscase,theOLSestimatesofequation(3)willnotbeconsistentandregressionresultswillbespurious. ThisimpliesthatthedistributionforthetandFstatisticswilldivergeasthesamplesizeincreasesgiving incorrectcriticalvalues(Phillips(1986)). Inordertoestimatethelongandshortrundemandformoney correctlyandbe ableto drawinferencesontheelasticities,wemustusethe cointegrationapproach. Thecointegrationapproach”dealswiththecaseinwhicha linearcombinationofnonstationary variablesis stationary. In general,a seriesX is integratedof orderd if afterdifferencingd timesit is 14

stationary(X-I(d)). ThroughoutthepaperIwillrefertoserieswhichareI(l) or differencestationary (d=l); thatisafterdifferencingoncetheyareI(0). LetX,be avectorofindependentvariablesincluding aconstant Zt=y,-pfxt t=l,2,3... (4) then, if ~ is the vector which will make z~stationarywe say that X(and Y~are cointegratedwith cointegrationvector ~(which need not be unique ifXL is multivariate). This cointegratingrelation (Y,=~’XJ is interpretedas the long run relationshipbetween Y and X, and z, is known as the “equilibriumerror”, sinceitmeasuresthedegreeto whichthesystemis outof equilibrium. Sincetheerror isstationary,therelationbetweenX andYwillreturntothemeaneventhough eachseriesindividuallywillmovewithoutthattendency.Allowanceismadeforthepossibilityofserially correlatedbuttemporarydivergencesfromthisrelationship. If Xand Yarecointegrated, thenOLSis theappropriatemethodto estimatethelongrun relationshipamongthem,andthecoefficientestimates willbeconsistent(Stock1987). However,theteststatisticswillbemeaningless.Thelongrun money demandfinction canthenbe estimatedby OLSif it isa cointegratingrelationship. Thecointegrationapproachcanalsobeusedtoestimatetheshortrundemandformoney. The representationtheoremby EngleandGranger(1987)indicatesthatserieswhicharecointegratedcanbe representedbyanerrorcorrectionmodel(ECM). ThisECMrepresentationcorrespondstotheshortrun relationshipamong these variablesconsistentwith the long run cointegratingequation. The ECM representationisas follows: wherez~.listhe“equilibriumerror”fromthecointegrationequation. SinceallthevariablesintheECM are I(0), OLSestimationprovidesconsistentestimatesandgoodteststatistics. In equation(5) agents 15

marginallyadjustytinresponseto laggedchangesinitselfandtheXtvariablesas wellasdisequilibria from”thelongruncointegratingequation(4). In thisECMframework,thematrixd canbe interpreted asameasureofthespeedwithwhichthesystemcorrectslastperiod’sequilibriumerror. Forthisreason, it isusuallycalledtheadjustmentmatrix. SECTIONV: THE LONGRUNDEMANDFORMONEY Thedataforallthecountriesarequarterlyfromdifferentsources. ForBolivia,thedataarefrom 1980:1to 1991:4fromUDAPE. ThedataforIsraelarefromtheBankofIsraelfrom 1970:1to 1990:4. Thedatafor Venezuelarunsfrom 1978:1to 1991:4andcomefromvariousIFS issues. V.1 Testingfor UnitRoots. Prior to estimatingthe long run demandfor real balances, each of the variablesmust be submittedto aunitroottestsincecointegrationmethodsrequirethatallthevariablesbeI(l). Totest the nullhypothesisthat eachvariableis nonstationaryI ran both DickeyFuller(DF) and augmented DickeyFuller(ADF)testsoneachofthefollowingseries:misthelogofrealMl (deflatedbytheCPI), y isthelogof realGDP, andn isthelogoftheinflationrate.lll Thegeneralformofthetestforany variableX is: TheDFtestomitsthesummationandbothofthetestsarerunwithandwithoutatrend. Thenumberof lags,k, isfour(4)whichiscommonforquarterlydata. Torejectthenullwerequireptobesignificantly negative. Tables2Ato 2C showtheresultsofthetestsfor thethreecountries. “Thedata for Israel were providedby RafiMelnickfrom the Bankof Israel, and for Boliviaby UDAPE( Unidadde AnalisisdePoliticasEconomical)inLa Paz. 1llForVenezuela,y isthelogofrealnonoilGDP. Alltheseriesareseasonallyadjustedexceptthe inflationrate. 16

TABLE 2A: BOLIVIA-UNIT ROOT TESTS 1980:1-1991:4 Variable DF(t) ADF(t) DF(nt) ADF(nt) --------------------------------------------------------------------------------------- Ieveh -3.24 -0.63 -3.25 -0.96 Y 7K -2.80 -2.25 -2.59 -1.90 m -1.09 -0.88 -1.75 -1.53 lst. Difference Ay --- --- -12.85 -2.50 An --- --- -10.55 -3.25 AM --- --- -7.71 -2.18 --------------------------------------------------------------------------------------- CriticalValues5% -3.50 -3.50 -2.9 -2.9 TABLE 2B: ISRAEL-~IT ROOT TESTS 1970:1-1990:4 Variable DF(t) ADF(t) DF(nt) ADF(nt) levels -4.53 -4.66 -1.40 -1.97 Y n -2.68 -2.49 -2.75 -2.58 m -0.06 -1.51 -0.86 -1.74 lst. Difference Ay --- --- -13.19 -3.37 An --- --- -12.33 -4.10 AM --- --- - 6.30 -2.58 Critical Values5% -3.50 -3.50 -2.9 -2.9

TABLE 2C: VENEZUELA-UNIT ROOT TESTS 1978:1-1991:4 Variable DF(t) ADF(t) DF(nt) ADF(nt) --------------------------------------------------------------------------------------levels Y -2.86 -3.09 -0.76 -0.39 n -4.20 -2.54 -3.64 -1.96 m -1.61 -1.94 -1.00 -1.09 lst. Difference Ay --- --- -11.83 -3.19 An --- --- -9.10 -5.13 AM --- --- -5.27 -3.02 --------------------------------------------------------------------------------------- CriticalValues 5% -3.50 -3.50 -2.9 -2.9 Theevidencefromthesetestsshowsthatwecannotrejectthenullhypothesisofaunitrootin thelevelsofy, n, andm. Thereare a fewexceptionsforeachcountrybutby far theresultsusingthe ADFtestshowthatthesevariablesare I(l). Forthefirstdifferences,allthetestsrejectthenullatthe 5% level. The exceptionsin eachof the casesalmostalwaysinvolvesthe DF test whichis the least powerfulofthetwotests. Underthiscriterion,andtakingintoaccountthelowpowerofthesetests,I concludethattheseseriesare nonstationary. Sincethe regressorsof themoneydemandfunctionare generatedbyanI(1)process,applyingOLSanalysistoitwillleadtomisleadingresults. Thecorrectway to estimatethemoneydemandfunctionistousetie cointegrationapproach. --V.2Cointe@ation Tests The evidenceaboveshowsthatthesevariablesare notstationary,thereforeto run OLSon a typicalpartialadjustmentspecificationwouldnotyieldtheappropriatecoefficientestimates. Toestimate a longrun moneydemandfor Bolivia,Israel, andVenezuelathefollowingcointegrationequationwas estimatedby OLSfor eachcountry. m,=~0+~IY,‘p2nf ‘Pf p,>o,p2<o (’7) .. To testforcointegration(i.e. totestfortheexistenceofa longrunequilibriumrelationship),I 18

ranADFandDFtestsonp~(the“equilibriumerror”)toseeifitwasstationary.we 1ofTables3A to 3C showsthe results. The evidencefor allthree countriesfailsto rejectthe nullhypothesisof RQ cointegration(i.e. thatp~isI(l)) for allthetests. Thismeansthatequation(7)isnota stablelongrun moneydemandfunctionfor anyofthethreecountriesstudied. This resultcanbe interpretedin termsof the modelpresentedin SectionII. If equation(1) representsthecorrectlongrunmoneydemandfunction,lackofcointegrationmaybeduetothefactthat we are ignoringtherole of thetransactionscostvariable,b. Previouspaperson the demandfor real balanceshaveshownthatthelackofstabilitycanbedueto “financialinnovation.” Wherethisisdefined astechnological,legalandinstitutionalchangeswhichallowpeopletoeconomizeontheirmoneyholdings (seeLaban(1991),deGregorioetal..(l992) andRoley(1985)).Inparticular,Melnick(1991)showsthat for Israel, ignoringa proxyfor financialservicesleadsto the misspecificationof the longrun money demandfinction andthelackof stability. I willshowthatthelackof stability,as isevidencedby the lackofcointegration,ofthelongrunmoneydemandfunctioninallthreeofthesecountriesisduetothe exclusionofaproxyfor financialinnovation. Iffinancialimovationisarelevantvariableinthedemandformoneyfinction, excludingitwill preventtherejectionofthenullhypothesisofnocointegration.Therefore,wecanagainhavespurious regressionresultsinequation(7). Previously,financialimovationhasbeenmodeledasafallintransactionscostsrepresentedby an interceptdummy(Laban 1991)or a timevaryingintercept(Arrau andde Gregorio 1991). In this model,I allowfinancialimovationto affect,apriori, theslopeas wellas theinterceptofthemoney demandfunction. Theeffectsof financialimovationare capturedby a setofthreedummyvariables: i)DXwhichisOpriortoyear X:1 and 1thereafter ii)DXYwhichisOpriortoyearX:1andequaltoy thereafterandiii)DXIwhichisOpriortoyearX:1 andequaltoz thereafter. WhereXistheyearineachcountrysamplewherefinancialimovationoccurs. In BoliviaX is 1986,inIsraelitis 1987,andinVenezuelait is 1989. Themodifiedlongrunmoney demandequationbecomes: (8) 19

Theestimatedequationsfor eachofthecountriesare as follows: m mt=17.93-1.46yl-2.93n,43.89D87, A.37D87Y1 +2.4D871, (9) T=83 ~2=.81 Dw=l.5 Israel m,*.97+.11 y, +.04n,-8.13D89 +.66D89Y,+.26D891, (lo) T$5 ~2 =.82 DW=l. 1 Venezuela m,=4.54 +1.18yt-.55z, -22.7D86, +2.14D86Y,-.42D861, (11) T=47 i2=.78 DW=l.5 Thestandarderrorsarenotreportedsincetheyhavedegeneratedistributions.Asisevident,the longrun elasticitiesofrealmoneybalanceswithrespectto incomehavetherightsign,buttheytendto bea-bithighwhencomparedwithotherestimates,exceptforIsrael. Thelongrunelasticitiesofmoney demandwithrespecttoincomeare2.91 forBolivia,0.77forIsrael,and3.32 forVenezuela. Thelong run semielasticitiesof inflationhavethe rightsignfor bothBoliviaandVenezuela,but notfor Israel. Thesesemielasticitiesallfallbetween-0.5and-1,whichisnotunusualforlessdevelopedcountries. The long run inflationelasticitiesare -0.5 for BoIivia,0.30 for IsraeI, and -0.97 for Venezuela. These coefficientestimateswillbe consistentaslongastheregressorsarenotcointegratedseparatelyandthe dummiesareincluded.(SeeTables3A-3C,line3). TheR2arealsoveryhighandtheDWstatisticsare 20

fairlycloseto 2, indicatingno seriousproblemswithserialcorrelation. - ofTables3Ato3Cshowstheresultsoftheunitroottestsontheequilibriumerrors(o’s) ofequations(9)-(11). Itisclearthatthedummyvariablesmatter. ForallthreecountriesIcannowreject thenullhypothesisofnocointegration,whichindicatesthattheseequationsprovideareasonableestimate ofthelongrundemandformoneyinthesecountries. Theevidencetendstosupportadownwardshift, as wellas a changeintheslopeofthelongrun equilibriummoneydemandfunctionat thetimewhen financialinnovationoccurredinthesecountries. AlloftheDXdummiescomeoutnegativeandlarge. Having estimateda stable long run demandfor money, after taking into accountfinancial innovation,InowestimatetheshortrundemandformoneyandshowI]owfinancialinnovationcanlead to a fasterspeedof adjustmentof realbalancesto changesin itsdeterminants. TABLE 3A: COINTEGRATION TESTS: BOLIVIA DF(t) ADF(t) DF(nt) ADF(nt) --------------------------------------------------------------------------------------- 1. Equation(8) -2.5 -2.3 -2.1 -1.7 2. Equation(9) -5.0 -2.3 -5.1 -2.3 3.Cointegration -3.0 -1.7 -3.1 -1.9 btn. y andn --------------------------------------------------------------------------------------- CriticalValues5% -3.5 -3.5 -2.9 -2.9 note: Four lagsused for ADF TABLE 3B: COINTEGRATION TESTS: ISRAEL DF(t) ADF(t) DF(nt) ADF(nt) --------------------------------------------------------------------------------------- 1.Equation(8) -3.8 -2.6 -3.7 -~.6 2. Equation(9) -4.4 -3.5 -4.1 -2.8 3.Cointegration -3.4 -2.5 -1.2 -0.75 btn. y andn --------------------------------------------------------------------------------------- CriticalValues5% -3.5 -3.5 -2.9 -2.9 The onlyexceptionistheregressionfor Israelthathasa DW statisticof 1.1. 21

TABLE 3C: COINTEGRATION TESTS: VENEZUELA DF(t) ADF(t) DF(nt) ADF(nt) --------------------------------------------------------------------------------------- 1. Equation(8) -1.8 -2.4 -1.8 -2.2 2. Equation(9) -5.0 -2.6 -5.0 -2.8 3. Cointegration -3.5 -3.5 -1.8 -1.2 btn. y andz --------------------------------------------------------------------------------------- CriticalValues5% -3.5 -3.5 -2.9 -2.9 SECTION VI: THE SHORT RUN MONEY DEMAND AND THE SPEED OF ADJUSTMENT:ANERRORCORRECTIONMODEL GiventhestablelongrunmoneydemandwhichwasestimatedinSectionV, I nowturntothe estimationofthedynamicspecificationforrealbalancesintheshortrun. Traditionalstudiesof money demandfor othercountrieshavealwaysuseda partialadjustmentapproachwhichis relativelyad hoc. Salmon(1982)demonstratesthatthismechanismwillonlyreachthedesiredleveloflongrunrealbalances ifthislevelisconstantinequilibrium,whichasmentionedbeforeisnotthecasewhenthevariablesare nonstationary.Additionally,Stock(1987)showsthatinferencesmadeonestimationsbyOLSwhenthe laggeddependentvariableis includedas a regressorcan leadto errors. Giventhesecriticisms,and followingthe RepresentationTheoremby EngleandGranger(1987),I use an error correctionmodel (ECM)toestimatetheshortrunmoneydemandforBolivia,Israel,andVenezuela. Thismodelisgiven by - (12) WhereAisthefirstdifferenceoperator,~~.listheestimateofthe “equilibriumerror”fromthe ... cointegrationequations(9)-(11)and~~iswhitenoise. Inordertoestimateequation(12)foreachofthe countriesin thesample,I followthemethodologyemployedby Hendryet al(1984). Thismethod,of 22

goingfromgeneraltospecific,appliedtoequation(12)impliesthattheequationiscontinuouslysimplified andreestimated. Itisfirstestimatedinitsmostgeneralformwithfourlagsfor eachvariableexceptthe errorcorrectionterm. Thefinalparsimoniousrepresentationisachievedafterdeletingalltheinsignificant variables. Theresultsforthefinalversionofeachcountry’sECMare showninTables4A-4C. IITABLE 4A: AN ERROR CORRECTION MODEL FOR BOLIVIA II IIDependentVar. isAm (1) (2) IIRegressors constant 0.004 0.008 (0.4) (0.7) Aq.l 0.43* 0.40* (3.6) (3.4) AA-3 O.So* 0.51* (4.5) (4.8) 1.6* 1.4* AYt (4.8) (4.1) -1.2* -1.2* AYt-3 (-3.3) (-3.3) An, -0.27* -O-3* (-4.2) (4.42) An,J -o.12* -o.10* (-2.5) (-1.9) ECtI -0.20* -0.35 (-2.6) (-3.0) DEC,-l ------ -0.27** (1.7) IIR2 0.71 0.72 II SSE 0.22 0.15 T 42 42 & t-statisticsare inparentheses,*= s]gmflcantat 5%, **= slgnlflcantat 10% 23

i TABLE 4A: AN ERROR CORRECTION MODEL FOR ISRAEL DependentVar. is Am (1) (2) Regressors constant -0.005 -0.004 (-0.8) (-0.7) A~.l 0.26* 0.27* (3.9) (4.0) Am,-~ 0.55* 0.51* (3.2) (2.9) AYt -0.84* 0.85* (-9.5) (-9.6) -005* AYt-3 -0.46* (-4.2) (-4.3) An, -0.29* -0.3* (-2.9) (-3.1) An,A -0.34* -0.33* (-3.7) (-3.7) EC,: -o.10* -0.09 (-2.9) (-2.7) DEC,-l ------ -0.31** (1.7) R2 0.69 0.69 SSE 0.17 0.16 T 79 , 79 t-statisticsare in paren t . h e s -e s, .*,.——slgnl e rl , can~a . t3 cm YO,T & T & = S -! I — gnl — LI - G :.&d A: I . Id - L * Ll 1 U nd YO ... 24

TABLE 4A: AN ERROR CORRECTION MODEL FOR VENEZUELA DependentVar. isAm (1) (2) Regr~ors constant -0.005 -0.006 (-0.7) (-1.0) Amt-4 0.63* 0.57* (6.2) (6.1) An, -0.96* 0.66* (-5.2) (-3.5) EC,., -0.29* -O.16* (-3.9) (-2.0) DEC,l ------ -0.52* (-3.6) ~2 0.59 0.67 SSE 0.11 0.09 T 54 54 -statlstlcsare inparentheses,*= slgmficantat 5%, **= slgnlflcantat 10% Column(1)of eachtableshowstheerror correctionmodelfor eachcountryin itsfinalform, afteralloftheinsignificantvariableshavebeeneliminated.Themodelshowsencouragingresultsforthe shortrunincomeandinflationelasticitiesofmoneydemand. ForBolivia,theshortrunincomeelasticity is0.37,andtheinflationelasticityis-0.4whichiswithintherangeofpreviousstudiesforlessdeveloped countries. In addition,the coefficienton laggedmoneyis about0.92 whichis consistentwithother studies. For Israel, the incomeelasticityis 0.5 which is in line with theoreticalspecifications,the inflationelasticityis -1.0, and the coefficienton laggedmoneyis about0.3. Finally,the resultsfor Venezuelaareasfollows:theinflationelasticityisapproximately-0.9, andthecoefficientonthelagged moneytermis0.63. Sinceoutputwasnotasignificantvariable,itselasticityisnotveryreliable,butit isapproximately1. Allthecoefficientsarehighlysignificant. Havingestimatedanappropriateshortrunmoneydemandforthesecountries,Inowturntothe 25

principalquestionof thepaper. In themodelof SectionII, I showedthata declineinthetransactions costs,or whatI havetermedfinancialinnovation,causespeopletoadjusttheirrealbalancesfasterthan before. Theerror correctionmodel,ECM,ofequation(12)specifiesthatthechangeinw dependsnot onlyonthe laggedvaluesof ytandZt,butalsoon theequilibriumerror thatoccurredin theprevious period. Viewed in this error correction framework, the matrix 6, the coefficienton o,.,, can be interpretedasameasureofthespeedbywhichthesystemcorrectslastperiod’sequilibriumerror. This iswhy5isusuallycalledthe“adjustmentmatrix.” InTables4A-4C,column(1)showsthattheECterm isalwaysoftherightsign(i.e. itisnegative)andhighlysignificant.Thisimpliesthatagentsaretaking intoaccountthelong runequilibrium error when adjustingtheirdemandfor real balances intheshortrun. When there is a positive error (i.e. when current moneyholdingsare greaterthanthedesiredones,m, > ret”)in thelongrun equation,peoplewilladjusttheirdesiredmoneybalancesdownward. Column(2)ofTables4A-4CshowthesameECMforeachcountrybutincludinganinteractive dummyvariablefortheerror correctionterm(DEC,.l). Notethatineachcasethecoefficientincreases inabsolutevalue,andisstatisticallysignificant.ThisconfirmsempiricallywhatSectionIIsetsout;that thespeedofadjustmentofmoneydemandtoitsdeterminantsincreaseswhenthereisfinancialinnovation. In essence,peopleadjustfastertodeviationsfromthelongrunequilibriumrelation. Thismakessense sincenowfinancialinstitutionsare moreefficientandpeoplecanputtheirmoneyindifferentassetsat . home. SECTIONVII: COCCLUSIONS I haveshownthatfinancialinnovationcanincreasethespeedofadjustmentofmoneydemand to itsdeterminants,andcanleadtotheinstabilitytypicallyfoundinothermoneydemandstudies. This is an aspect of the “literaturewhich has not been exploredmuch, particularlyin terms of the new cointegrationmethods. ,. Usingthe appropriatecointegrationtechniques,I haveshownthatby introducinga proxyfor 26

financialinnovation,a stablelongrunmoneydemandfunctioncanbe obtainedfor eachcountry. For Bolivia,Israel,andVenezuela,theempiricalestimatesshowthatthelongrundemandformoneynotonly shifteddown,butthatintheshortruntheeffectof financialinnovationhasbeento increasethespeed withwhichpeopleadjusttheiractualmoneyholdingsto theirdesiredmoneyholdings. Viewedinthe Miller-Orrtransactionsdemandfor moneyframework,a fallinthetransactionscostvariablemeansa shorterperiod in whichdesired moneybalancesare not equalto the optimalmoneybalances. The empiricalevidenceshowsthatthecoefficientontheerror correctionvariableincreasesinabsolutevalue indicatingthatoncefinancialinnovationtakesplaceanydisequilibriabetweendesiredandactualmoney holdingswillby eliminatedfaster. 27

REFERENCES Arrau, Patricio,Jose De Gregorio, CarmenReinhartand PeterWickham,(1991), “TheDemandfor Money in DevelopingCountries:Assessingthe Role of FinancialImovation,” 1~F Workingpaper No.91/45 Baumol,W.J(1952),“TheTransactionsDemandforCash:AnInventoryTheoreticApproach,”Quarterly Journal of Economics, 66, 545-556. Ben-Bassat,A. andMarom,A. (1988),“IstheDemandforMoneyinIsraelStable?(1965-1983),”Bank of Israel Economic Review, N 60 (January),p.52-71. Ben-Bassat,A. (1992),“CapitalMarketReforminIsrael,”Bank ofIsraelEconomic Review, N 65, p.17- 30. Blanchard,OlivierandStanleyFischer,LecturesonMacroeconomics(Cambridge,Massachusetts:MIT Press, 1989). Bruno,MandMeridor,L.R. (1991),“TheCostlyTransitionfromStabilizationto SustainableGrowth: Israel’s Case,” in BrunoM., S. Fischer, E. Helpman,N. Liviatanand L. Meridoreds.,Lessonsof EconomicStabilizationandItsAftermath. TheMITPress Cagan,P. (1956), “TheMonetaryDynamicsof Hyperinflation”, in Studies in the Quantiw Theory of Money, ed. M. Friedman,Chicago:Universityof ChicagoPress, pp.25-117. Campbell,J.and Perron,P. (1991), “Pitfallsand Opportunities:WhatMacroeconomistsShouldKnow AboutUnitRoots.”NBERMacroAnnual1991.M.I.T. Press. Engle,R.F., andGranger,C.W.J(1987),“CointegrationandErrorCorrection:Representation,Estimation andTesting,”Econometric, 55, 251-276. Engle, Robert F. and B.S. Yoo, “Forecastingand Testing Co-integratedSystems,” Journal of Econometrics, (1987) 143-159. Goldfeld,StephenM., TheCaseof MissingMoney,”Brookings Papers on Economic Activi~’, (1976) 683-730. Hafer, R. W., andJansen,DennisW.(1991), “TheDemandforMoneyintheUnitedStates:Evidence fromCointegrationTests,“Journal ofMoney, Credit,and Banking, VOI.23, No.2 (May1991),155-168. Hendry, F.D., Pagan, A.R., and Sargan, J.D. (1984), “DynamicSpecification”, in Handbookof Econometrics (VO1.2),eds. Z. GrilichesandM.D. Intriligator,Amsterdam:North-Holland,pp. 1025-1100. Laban,R. (1991)“FinancialInnovationandtheStabilityofMoneyDemand:EvidencefromArgentina andChile,”M.I.T Chapter3 ofPh.D. thesis 28

Leiderman,LandMarom,A.(1988),“NewEstimatesoftheDemandforMoneyinIsrael,”Bank ofIsraeZ Economic Review, N 60 (January),p.19-35. Melnick,R.,(1988), “TwoAspectsof the Demandfor Moneyin Israel, 1970-1981”, Bank of Israel Economic Review, N 60 (January),p.36-52. Melnick,R., (1990), “TheDemandfor Moneyin Argentina1978-1987:BeforeandAftertheAustral Program,”Journal of Business and Economic Statistics, 8, N4, p427-434. Melnick,R., (1991),“FinancialServices,Cointegration,andtheDemandforMoneyinIsrael,”Bankof Israelmanuscript Miller,StephenM. (1991),“MonetaryDynamics:AnApplicationofCointegrationandError-Correction Modeling,”Journal of Money, Credit, and Banking, VO1.23,No.2 (May 1991),139-154. Morales,J.A;(1991),“TheTransitionfromStabilizationto SustainedGrowthinBolivia,”inBrunoM., S. Fischer, E. Helpman,N. Liviatanand L. Meridoreds.,Lessonsof Economic StabilizationandIt$ ~. TheMITPress Morales,J.A;(1988), “La Inflaciony la Estabilizacionin Bolivia,” in Bruno M., G.Di Tella, R. . . . Dornbusch,andS. Fischereds.,~nflaciony Establhzacion:LaExDerlenciadeIsrael.Argentina.Brasilz ~oliviav Mexico. El TrirnestreEconomicoN.62 Offenbacher,E.K. (1988),“EmpiricalStudiesoftheDemandforMoneyinIsrael:Introduction,”Bank of Israel Economic Review, N 60 (January),p.1-18. Perron, Pierre. (1988),“TrendsandRandomWalksinMacroeconomicTimeSeries:furtherEvidence froma NewApproach,”Journal of Economic Dynamics and Control 12 (1988) 297-332. Phillips,Peter C.B.,(1986), “UnderstandingSpurious Regressions in Econometrics.” Journal of Econometrics, N33,p.311-340. Piterman,S.(1988),“TheIrreversibilityoftheRelationshipBetweenInflationandRealBalances,”Bank of Israel Economic Review, N 60 (January),p.72-83. Stock,JamesH.(1987),“AsymptoticPropertiesofLeastSquaresEstimatorsofCo-IntegratingVectors,” Econometric, N 55, 1035-1056. TheEconomistIntelligenceUnit,CountryProfile:Venezuela.Suriname.NetherlandsAntilles.1988-1992. 29

International Finance Discussion Papers IFDP Number Titles Author(s] 1996 567 FinancialInnovationAndTheSpeedofAdjustment MartinaCopelman of MoneyDemand: EvidenceFromBolivia, Israel,AndVenezuela 566 Long-TermEvidenceontheTobinandFisher ShaghilAhmed Effects: A NewApproach - JohnH. Rogers 565 SomeEvidenceontheEfficacyoftheUKInflation ChanHuh TargetingRegime: An Out-of-SampleForecast Approach 564 TheUseoftheParallelMarketRateasa Guide NitaGhei to SettingtheOfficialExchangeRate StevenB.Kamin 563 CountryFundDiscountsandtheMexicanCrisisof JeffreyA. Frankel December1994: DidLocalResidentsTurn SergioL. Schmukler PessimisticBeforeInternationalInvestors? 562 EasternEuropeanExportPerformanceduring NathanSheets theTransition SimonaBoata 561 Inflation-AdjustedPotentialOutput JaneT. Haltmaier 560 TheManagementof FinancialRisksatGerman AllenB.Frankel NonfinancialFirms: TheCaseofMetallgesellschafi DavidE.Palmer 559 BroadMoneyDemandandFinancialLiberalization NeilR.Ericsson SunilSharma inGreece . 558 StockholdingBehaviorofU.S. Households:Evidence CarolC.Bertaut fromthe 1983-89Surveyof ConsumerFinances 557 FirmSizeandtheImpactof Profit-MarginUncertainty VivekGhosal on Investment:Do FinancingConstraintsPlayaRole? PrakashLoungani 556 RegulationandtheCostof CapitalinJapan: ACase JohnAmmer Study MichaelS.Gibson 555 TheSovereigntyOption: TheQuebecReferendumand MichaelP. Leahy MarketVie~s ontheCanadianDollar CharlesP. Thomas Pleaseaddressrequestsfor copiesto InternationalFinanceDiscussionPapers,Divisionof InternationalFinance,Stop24,Boardof Governorsof theFederalReserveSystem, Washington,DC 20551. 30

InternationalFinanceDiscussionPapers IFDP Number Titles Author(s) 1996 554 RealExchangeRatesandInflationinExchange-Rate StevenB.Kamin BasedStabilizations:An EmpiricalExamination 553 MacroeconomicStateVariablesasDeterminants JohnAmmer of AssetPriceCovariances 552 TheTequilaEffect: TheoryandEvidencefrom MartinUribe Argentina 551 TheAccumulationofHumanCapital: Alternative MuratF. Iyigun MethodsandWhyTheyMatter AnnL. Owen 550 AlternativesinHumanCapitalAccumulation: MuratF. Iyigun ImplicationsforEconomicGrowth AnnL. Owen 549 MoreEvidenceontheLinkbetweenBank MichaelS.Gibson HealthandInvestmentinJapan 548 TheSyndromeof Exchange-Rate-Based EnriqueG. Mendoza StabilizationandtheUncertainDurationof MartinUribe CurrencyPegs 547 GermanUnification: WhatHaveWeLearned JosephE. Gagnon fromMulti-CountryModels? PaulR.Masson WarwickJ.McKibbin 546 Returnsto ScaleinU.S.Production: Estimates SusantoBasu andImplications JohnG.Femald 545 Mexico’sBalance-of-PaymentsCrisis: A Chronicle GuillermoA. Calvo of DeathForetold EnriqueG. Mendoza 544 TheTwinCrises: TheCausesof Bankingand GracielaL.Kaminsky Balance-of-PaymentsProblems CarmenM.Reinhti 543 HighRealInterestRatesintheAftermathof GracielaL.Kaminsky Disinflation:Is ita Lackof Credibility? LeonardoLeiderrnan 542 PrecautionaryPortfolioBehaviorfromaLife-Cycle CarolC.Bertaut Perspective MichaelHaliassos 541 UsingOptionsPricesto InferPDF’sforAssetPrices: WilliamR.Melick AnApplicationto OilPricesDuringtheGulfCrisis CharlesP. Thomas 31

International Finance DiscussionPapers IFDP Number Titles Author(s) 1996 540 MonetaryPolicyintheEnd-Gameto Exchange-Rate StevenB.Kamin BasedStabilizations:TheCaseof Mexico JohnH. Rogers 539 ComparingtheWelfareCostsandtheInitialDynamics MartinUribe of AlternativeTemporaryStabilizationPolicies 538 LongMemoryinInflationExpectations:Evidence JosephE.Gagnon fromInternationalFinancialMarkets 537 UsingMeasuresof Expectationsto Identi$ the AllanD. Brunner Effectsof a MonetaryPolicyShock 536 RegimeSwitchingintheDynamicRelationship ChanHuh betweentheFederalFundsRateandInnovationsin NonborrowedReserves 535 TheRisksandImplicationsofExternalFinancial EdwinM.Truman Shocks: LessonsfromMexico 534 CurrencyCrashesinEmergingMarkets: An Jefiey A.Frankel EmpiricalTreatment AndrewK. Rose 533 RegionalPatternsintheLawof OnePrice: The CharlesEngel Rolesof GeographyVs.Currencies JohnH. Rogers 32