Currency substitution and nonlinear error correction in Taiwan's demand for broad money

Abstract

We modify the conventional money demand function by including a real exchange rate variable to reflect the effect of currency substitution. Empirical evidence indicates that the variable is crucial to the long-run stability of Taiwan's money demand. After finding the failure of a linear error-correction model in describing the dynamics of Taiwan's money demand, we apply a non-linear errorcorrection model to examine its dynamics and support the appropriateness of the non-linear model empirically. JEL: E41, C22