ANALYSING THE EFFECT OF INTEREST RATES ON MONEY DEMAND USING AUTOREGRESSIVE DISTRIBUTED LAG (ARDL) MODELS

Abstract

This research examines quarterly data spanning from 2008 to 2023 to investigate the interrelationship between government revenue, money demand, and both lending and deposit interest rates in Jordan. The objective is to shed light on the interactions among money demand, interest rate variability, and income fluctuations. Specifically, the study evaluates how lending interest rates (LIR), deposit interest rates (DIR), and gross domestic product (GDP) influence the broad money supply (M2). To assess both the short-run and long-run dynamics among these variables, the study employs the bounds testing procedure for cointegration, particularly through the Autoregressive Distributed Lag (ARDL) model. Unit root test outcomes indicate that the variables are integrated at mixed orders, I(0) and I(1), justifying the application of the ARDL methodology. The bounds test confirms the existence of a long-term equilibrium relationship among the selected variables. Nevertheless, the long-run coefficients do not suggest statistically significant causal effects of the explanatory variables on money demand. Diagnostic tests affirm that the model does not exhibit issues such as serial correlation, heteroscedasticity, or misspecification. The empirical evidence contributes to a broader understanding of monetary transmission mechanisms in economies characterised by fixed exchange rates and nascent, developing financial sectors. The findings reveal that lending interest rates exert a negative influence on long-run money demand, while deposit interest rates maintain a positive yet marginal impact. In contrast, short-run money demand appears insensitive to interest rate changes. Moreover, the results demonstrate that the model’s parameters are stable over time, with an estimated speed of adjustment towards long-run equilibrium of 3.8%. The study recommends that the Central Bank adopt measures to stabilise interest rate fluctuations, thereby enhancing the appeal of commercial banks to potential depositors and supporting private sector investment activities.