Demand for money in Tanzania: a test of the Mckinnon model

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University of Dar es Salaam
This study investigates the determinants of the demand for money in Tanzania. The study tests whether the demand for money in Tanzania follows the traditional approach that is, investment and demand for money substitute each other (Keynesian and Neoclassical theories) or as per McKinnon Complementarity hypothesis, that is investment and demand for money complement each other. This study specifically tests the applicability of McKinnon model because currently, following the financial sector liberalization, interest rates are still not adequate stimulants to the economic performance. In addition, economic restructuring has led to the expansion of the informal sector, therefore the traditional approach may not necessarily match the current economic situation. The McKinnon's model was applied by Ajewole (1989) in the study of determinants of demand for money (a test of McKinnon Model) for the case of Nigerian economy and Matovu (1995) in a similar study for the case of Ugandan economy. Using the Error Correction Model (ECM) and Ordinary Least Squares (OLS) estimation techniques, the main hypothesis that investment is positively related to demand for money and other hypotheses are empirically tested for the period 1968(1)-1994(IV). The ECM model in this study is able to provide both short-run and long-run relationships between demand for money balances and other explanatory variables (income, return on physical capital rate of interest). This model is able to show that the process of adjustment to the general equilibrium is very slow. So individuals take time to adjust their demand for money balances if any change takes place in the money market. The empirical results confirmed the hypothesis that, in Tanzania investment is positively related to both demand for money and income. The results reveal further that demand for money is negatively related to real rate of interest. To test for structural breaks before and after financial liberalisation (1968-1985) and (1986 1994) in order to analyse the stability of demand for money function, Chow test is applied. The results show that there were structural breaks between these two periods that is before and after financial sector liberalisation. During the liberalisation era (1986-1993) broad definition of money explained better the demand for money in Tanzania. It is therefore recommended that, to regulate money supply requires the regulating of currency in circulation and demand deposits. This can be done by expanding income generating activities that will result into the increase in people's income.
Available in print form
Tanzania, Demand for money
Isaka, I(1997) Demand for money in Tanzania: a test of the Mckinnon model, masters dissertation, University of Dar es Salaam. Available at ( )