Modeling Money Demand in the United Arab Emirates

Using cointegration and error-correction, this paper develops and tests a money demand model for the small open economy of the United Arab Emirates. The paper takes into account the possible role of the international opportunity costs (as proxied by foreign interest rates and exchange rates) in modeling money demand. The empirical results are subjected to a battery of various tests to examine their statistical adequacy and structural stability. The variables that exert significant effects on money holdings in the UAE are non-oil real GDP, expected inflation, exchange rate movements, and the error-correction term. Among other implications, the results suggest the presence of currency substitution in the UAE economy, a phenomenon that must not be ignored by monetary authorities in the country. The results also indicate that M1 possesses a well- behaved and a stable demand function, but M2 and M3 do not. Several tests confirm the high degree of stability (forecastability) of the proposed M1 demand model and support the use of M1 as an intermediate target for monetary policy in the United Arab Emirates