nominal rate was even been below one percent recently.<sup>8</sup> It is thus clear that interest rates are not good measures of the costs or returns of holding money, and standard formulations of money demand are unlikely to work well.<sup>9</sup> Another challenge to estimating money demand is the lack of monthly observations on income: only annual data on GDP are available. The annual GDP series, measured in millions of Birr at 1999/2000 prices, thus had to be interpolated.10 Although the interpolation does not create any useful information about short-run fluctuations in income, it produces a monthly series that measures the trend in GDP, which is the relevant variable for long-run money demand analysis.

One way of highlighting the long-run relationship between income, the price level and the money stock, measured as broad money,11 is to graph the log of velocity _y-(m-p_ ). Figure 3 shows that velocity had an inverse U-shape over the period 1999:12008:11 with a sharp increase during 2007. Thus, it is not a stationary series.<sup>12</sup> Furthermore, adjusting the coefficient on _y_ , which is unity in the velocity formulation, to other economically realistic values does not make the combination of _m-p_ and _y_ stationary _._ This means that to develop a long-run money demand model, we need to look for non-stationary variables that together with _m, p_ and _y_ form a stationary vector.

Since the interest rates are not useful, the only standard candidates are inflation, which measures the cost of holding money instead of goods, and the rate of change of the value of foreign currency, which measures the cost of holding domestic currency instead of foreign currency. Even though there are restrictions on capital flows in Ethiopia, some people hold foreign currency as an alternative to broad money. It could

> 8 The real interest rate was calculated with current annual inflation using CPI data from the Central Statistical Agency. The Treasury bill rates are those reported in the IFS database. It is important to mention that the reason for excess liquidity is not clear. A lack of investment opportunities for the banks and mal-functioning of Ethiopia’s financial sector is likely to be one explanation. The capital account is closed, and when banks lend to firms the money ends up in bank accounts, increasing their liquidity. In other words, even  low yields of treasury bill may be better than nothing.

> 9 Tadessea and Guttormsen (2008) find that the interest rate change in formal financial markets appears to have no effect on cereal price dynamics, suggesting that speculative decisions are not correlated with interest rates in formal financial markets.

> 10 The interpolation was done with RATS assuming a random walk. The Denton method, which combines annual data with other high frequency data, would be preferable. However, the by far the most important variable causing short-run fluctuations is agricultural output, but it is only available at an annual frequency.

> 11 Money demand was modeled using both M1 and broad money. The results were very similar so only the results for broad money are reported.

> 12 A non-stationary series for velocity is not an uncommon finding, see for example Hendry and Erisson (2002) for the UK. Another reason for finding an I(1) process maybe related to sample size.

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