The Relative Importance of Inflation and Currency Depreciation in the Demand for Money: An Application of the Estimation by Simulation Method to the German Hyperinflation

Jesús Vázquez, Universidad del País Vasco

Abstract

The model introduced assumes that the demand for money is a function of the expected inflation rate and expected depreciation rate of the domestic currency, characterizing the costs of holding money. In addition, the depreciation rate is assumed to follow a crawling peg rule in which the rate of depreciation is adjusted in proportion to the gap between the rate of inflation and the rate of depreciation. This model is estimated using a GMM technique called estimation by simulation. The empirical results show that the model introduced in this paper fits the data better than Cagan's model. Moreover, they show that foreign nominal assets were closer substitutes for domestic money than were real assets during German hyperinflation.