Stability of the Demand for Real Narrow Money in Indonesia : Evidence from the Pre and Post Asian Crisis Era

The stability of the demand for real M1 in Indonesia is empirically examined using quarterly data between 1981 and 2002. A cointegrated VAR methodology that isolates the period of structural breaks in the data generating process of the variables, caused by the Asian crisis, is used. The results show that the nominal M1 demand function is long run homogenous in the price level and the price level itself is endogenous in the equation for nominal M1. Therefore, a reparameterization towards the real M1 demand function is necessary. In the pre and post Asian crisis era, the demand function for real M1 in Indonesia is empirically stable and consists of a small number of variables. In the long run, the real private household consumption spending forms the permanent part of the demand for real M1 balances. Meanwhile, in the short run, the opportunity cost of holding real M1 balances, measured by the 1-month nominal interest rate of time deposits in commercial banks, and agents' seasonal preference for real money balances, are key determinants of the demand for real M1 balances. In addition, there is evidence of a co-breaking relationship between the real M1 balances and the real private household consumption spending in Indonesia during the Asian crisis