The Demand for Money, Structural Breaks and Monetary Policy in the Gambia

Abstract

As part of the IMF sponsored stabilization  programme, the Gambia has been pursuing base monetary targeting. To ascertain whether this policy framework satisfies the necessary condition for effectiveness, this paper presents an empirical investigation into the determinants and stability of money demand (M2)   in the short-run and long-run in the Gambian economy during the period 1986:1 - 2012:4. Using theoretical defensible specification of the money demand function in line with the Keynesian precautionary, transacation and  speculative motives for holding money and its various extensions by Friedman, Baumol and Tobin, the paper  applied  Gregory -Hansen cointegration techniques allowing for structural breaks. The papers finds the existence of a long run and short-run cointegration relationship  in the money demand function and its determinants namely income, interest rate, inflation and exchange rate in the Gambia. The cointegration relationship with breaks suggests a structural break which occurred in 1995:1 reflecting the military coup and fall in foreign aid in the Gambia during the period.  The structural break is also clearly identifiable with the 50% devaluation of the CFA franc,  the border closure and transit controls in Senegal, as well as the suspension of convertibility  of the  CFA franc outside the franc zone in the period 1994-1996. Through establishing  the existence of a  dynamic short-run  error correction model we found that cointegration model with intercept shift best characterize the equilibrium relationship of the money demand function when there exists a structural break.   Furthermore,  by  the cumulative sums of squares of recursive residuals test, the CUSUM and CUSUMSQ tests, we found that the money demand function is unstable both in the short-run and in the long-run during the period under investigation.  Consequently the continued use of monetary targeting by the Central Bank of the Gambia (CBG) is misguided and suboptimal. This is even more so because there is no statistically significant relationship between money supply and inflation.  The Central Bank of the Gambia  (CBG) should  adopt  instead a flexible combination of elements of inflation targeting and monetary supply target framework to  maintain price stability  and promote noninflationary economic growth.