Financial Innovation and Money Demand: Evidence from Sub‐Saharan Africa

• Author: John Paul Dunne,Elizabeth Kasekende
• DOI: http://doi.org/10.1111/saje.12205
• Date: 01 December 2018
• Published date: 01 December 2018

© 2018 Economic Society of Sout h Africa . Doi :10.1111 /saj e.1 220 5

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South African Journal of Economics Vol. 86:4 December 2018

FINANCIAL INNOVATION AND MONEY DEMAND:

EVIDENCE FROM SUB-SAHARAN AFRICA

JOHN PAUL DUNNE† A ND ELIZABE TH KASEK ENDE*

Abstract

While the ef fect of financia l innovation on money demand has been w idely researched in

industriali sed countries, because of its m ajor role in monetary policy, few studies have focu sed

on developing countries. Thi s is surprising given the considerable growth i n financial innovation

in Sub-Saha ran Africa i n recent years and its potential i mplications for developing country

macroeconomic policy. This paper invest igates the development of fina ncial innovation and its

impact on money demand in the region u sing panel data estimation techniques for 34 c ountries

between 1980 and 2013. The results indicate that t here is a negative relationship bet ween

financia l innovation and money demand. Th is implies that fin ancial innovation plays a crucia l

role in explaining money dema nd in Sub-Sahara n Africa and given i nnovations such as mobile

money in the region this ca n have important implications for future policy de sign.

JEL Classifica tion: E41

Keywords: Money de mand, financial innovation

1. INTRODUC TION

Understanding the relationship between money demand and its determinants has been

an important research focus over the years, mainly because of its importance for mone-

tary policy. In particular, countries that conducted monetary policy through monetary

aggregate targeting needed money demand to be predictable and stable. Recently, the

stability of money demand has become an issue of debate, with suggestions that the

traditional money demand relationships have changed in a number of countries. The

breakdown in the relationship between monetar y aggregates and variables such as in-

come and inflation has been argued to have been an important reason for the failure

in the monetary aggregate targeting in a number of countries, such as New Zealand,

United Kingdom, Canada and Sweden among others, leading them to move to inflation

targeting (Mishkin, 1999). As well as instability, traditional money demand functions

have also exhibited highly autocorrelated errors, implausible parameter estimates and

persistent over prediction (Arrau et al., 1995). A potential explanation for this instability

and misspecification of the money demand function is the rapid growth in f inancial

innovation, which has been apparent in developed economies and has been an i ncreasing

characteristic of developing economies (Lieberman, 1977; Arrau and De Gregorio, 1991).

While studies based on industrialised countries, such as Lippi and Secchi (2009),

Attanasio et a l. (2002), Arrau and De Gregorio (1993) and Alvarez and Lippi ( 2009) have

* Correspond ing author: School of E conomics, Universit y of Cape Town, Cape Town, South Af rica. E-mai l: lizkaseke nde@gmail.co m

† Economic Res earch Depart ment, Bank of Ugand a, Kampala, Ug anda.

South African Journal

of Economics

Doi :10.1111 /saj e.1 220 5© 2018 Economic Society of Sout h Africa .

South African Journal of Economics Vol. 86:4 December 2018 429

found financial i nnovation to have had an impact on money demand, few have analysed

this relationship in developing countries. Ka rarach (2002), Ndirangu and Nyamongo

(2015), and Augustina et al. (2010) provide useful case st udies. This is despite the fact

that Sub-Sa haran Africa has seen considerable financial innovation, particularly during

the last decade. Following the f inancial reforms and liberalisation of exchange rates, a nd

interest rates in the 1980s and 1990s, recent innovations have included the introduction

of ATMs, debit cards and, more recently, mobile money, which started in Kenya in 2007

and quickly spread to other countries. This grow th in financia l innovation could have

important implications for monetary policy in t he region, as most countries in Afr ica still

use monetary agg regate targeting, except for a few countries such as South A frica, Ghana

and Uganda which moved to inf lation targeting.

In this paper, the effect of financial innovation on money demand in Sub-Saharan

Africa is considered using a pa nel of 34 countries for the period 1980 to 2013. Few studies

have focused on Sub-Sahara n African countries, and those that have are genera lly country

case studies. Th is paper specifies a money demand equation that takes acc ount of financial

innovation and estimates it using dynamic panel data estimation techniques. In doing so,

it evaluates the likely impact of the innovations. The next section provides a review of the

literature, followed by the data, model specific ation and estimation in section 3. Section 4

then presents and discusses the results and some conclusions are considered in section 5.

2. LITER ATURE REV IEW

A range of theories exist that link the quantity of money demanded to the real sector

of the economy (Sriram, 2000). Classical economists argued that money is a medium

of exchange and developed the transaction demand for money, which depicts the rela-

tionship between the quantity of money in circulation and the volumes of transactions

and price. This led to the quantity theory of money, which sees income as the primary

determinant of money (Serletis, 2007). Keynes and the Keynesians then developed the

quantity theory of money to include interest rates, arguing that individuals hold money

for three reasons: the transaction/business motive, the precautionary motive and the

speculative motive. The transaction demand and precautionary dema nd reflect the role

of money as the medium of exchange, with income playing a major role in determining

money demand, while speculative demand reflect s the role of money as a store of value,

with individuals deciding between holdings of money or bonds. This makes interest

rates, which are negatively related to money demand, important in the money demand

specification (Sriram, 1999; Serletis, 2007). A third set of theories, commonly referred

to as post-Keynesian, is often grouped based on whether money is used as a medium of

exchange or a store of value (Sriram, 1999). Theories that are grouped under money as

medium of exchange are referred to as transactions theories. Examples of these include

the Baumol–Tobin model, the shopping time model and the cash in advance models.

Portfolio theories assume that money serves as a store of value and include the overlap-

ping generation models and the Tobin’s theory of liquidity preference (Serletis, 2007).

In empirical work, money demand specifications have generally included income and

interest rates as the main determinants of money demand and increasingly the potential

role of financial innovation in reducing tra nsaction costs is being recognised. There are,

however, some differences in definition. For instance, Melnick and Yashiv (1994, p.2)