Effects of Financial Innovation on the Demand for Money: Evidence from Bangladesh

Abstract

Empirical analyses of the money demand function in Bangladesh typically consider only income level and the interest rate. This study estimates the traditional money demand function alongside extended models incorporating financial innovation and the exchange rate for comparative analysis. After establishing a long-term relationship between monetary aggregates (M2 or M3) and their determinants, the models are estimated. In the traditional model, both income level and the interest rate are statistically significant with the expected signs. However, when including financial innovation and the exchange rate, the interest rate remains significantly negative, financial innovation becomes significantly positive, and income level loses significance. This suggests that money demand drivers have shifted from income level and the interest rate to the interest rate and financial innovation. As mobile financial services expand, the velocity of money may increase and introduce volatility in monetary aggregates. Therefore, monetary policy formulation should effectively account for financial innovation.