Tests of the Functional Form, the Wealth Effect, Currency Substitution, and Capital Mobility for Taiwan's Money Demand Function

Abstract

The Box–Cox transformation indicates that the log-linear form for M2 demand cannot be rejected while the Fair (1987) specification and the linear form can be rejected at the 5% level in favor of general functional form. M2 demand is positively influenced by real GDP, the deposit rate, and the real stock price and negatively affected by the nominal exchange rate, the foreign interest rate, and the expected inflation rate. Hence, the wealth effect of an increased real stock price is greater than the substitution effect. The substitution effect of the deprecation of the New Taiwan dollar dominates the wealth effect. The capital mobility effect of an increased foreign interest rate is greater than the cost of borrowing effect. The general functional form for M2 demand performs better in forecasting than the Fair specification and the linear form.