Selection of the Scale Measure in Narrow Money Demand: The Cases of Japan and Germany

Abstract

The purpose of this paper is to apply pair-wise and multiple-alternative nonnested tests to the choice of the scale variable in the money demand functions of Japan and Germany. Findings based on the multiple-alternative procedure indicate that domestic absorption (income minus net exports) is the appropriate scale variable in the money demand function of Japan, while pair-wise tests produce somewhat mixed results. For Germany, private consumption is found to be the proper scale variable in the narrow money demand function by both type procedures. These findings contrast with the established literature that uses income measures as the scale variable. The choice of domestic absorption in Japan by the multiple-alternative procedure provides a role not only for consumption, which correlates with income measures, but also for investment and government spending, as determinants of the level of monetary balances held. The choice of consumption as the appropriate scale variable for Germany supports the shopping time model of money demand and the Mankiw-Summers proposition. These results have implications on formulation of monetary policy and the magnitude of the effect of fiscal policies such as government spending and tax cuts.