Effect of financial innovation on money demand in the East African Community

Abstract

Tremendous changes have been witnessed in the East African Community’s (EAC’s) macroeconomic landscape over the past few years. For instance, several forms of financial liberalizations have been witnessed in the EAC over the years. These changes can shift various parameters of the money demand model. Many previous empirical studies examined the effect of scale and opportunity cost of holding money variables on money demand. However, there are some that left out financial innovation which is one of the key factors influencing money demand. Additionally, they are just country specific studies and used time series data analysis technique. It is in this backdrop that a cross-country case study that examines the effect of financial innovation on money demand function was carried out using the recent data and a different analysis technique which is panel data analysis. The objective of the study was to examine the effect of mobile money and ATMs on money demand in the EAC. The study’s control variables were real GDP and interest rate. The study’s theoretical framework was Keynesian theory of money demand and adopted a historical research design. The study used secondary data for the period 2007 to 2020 and this data was obtained from the World Bank and International Monetary Fund. Both descriptive and inferential analyses were carried out. Levin- Lin-Chu test for panel unit root was done and all the study variables were found to be stationary at level. Hausman specification test was carried out and the results of this particular test indicated that fixed effects (FE) model was the preferred model. Wooldridge test for serial correlation indicated that autocorrelation was not a problem in the regression analysis. The results of modified Wald test for heteroskedasticity also indicated that heteroskedasticity was not a problem in the regression analysis. Breusch-Pagan LM test of independence was also conducted and the results showed that there was no cross-sectional dependence. The results of balanced panel fixed effects regression analysis indicated that mobile money, ATMs, and real GDP were affecting money demand positively and their effects were also statistically significant. However, interest rate affected money demand negatively. Mobile money and ATMs were proxies for financial innovation whereas real GDP and interest rates were control variables. Therefore, it was observed that financial innovation has had a positive effect on money demand in the EAC. The findings of this study might be of great importance to monetary authorities and policy makers in the EAC. Future research studies can expand the period of study similar to this one and also increase the number of countries involved.