Effect of financial innovation on money demand and it’s stability : evidence from East Africa

Abstract

This research employed the Autoregressive Distributed Lag Model and conducted stability tests using the CUSUM and CUSUMSQ methods to investigate the effect of financial innovation on money demand and its stability in East Africa. The study specifically focused on understanding the impact of income and exchange rates on money demand, analyzing the influence of financial innovations on money demand; and assessing the long-term stability of money demand. The Pooled Mean Group (PMG) estimation results reveal that real GDP, real interest rates, consumer prices, nominal exchange rates, and financial innovation are key determinants of money demand in East Africa. In the long run, real GDP significantly increases money demand when financial innovation is considered, with a coefficient of 0.967, compared to an insignificant 0.789 without financial innovation. Interest rates negatively impact money demand, with coefficients of -0.129 and -0.135 in the models without and with financial innovation, respectively. Inflation significantly reduces money demand, and its effect is stronger with financial innovation (-1.540 compared to -1.358). The nominal exchange rate has a negative effect, with coefficients of -0.467 and -0.464 in the respective models. Automated Teller Machine (ATM) availability increases money demand (0.05), highlighting the role of financial technology. The error correction term (ECT) indicates short-run adjustment, with disequilibrium corrected by 29-37% per period. Stability tests using CUSUM and CUSUM² show that money demand in Uganda, Kenya, and Tanzania remains stable with financial innovation, while Rwanda and Burundi exhibit instability that financial innovations help mitigate. From a policy standpoint, this research highlights the importance of fostering economic growth, maintaining stable exchange rates, and effectively managing the integration of financial innovations within the financial system.