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Investigating Stability and Linearity of a German M1 Money Demand Function

Starting from a linear error correction model (ECM) the stability and linearity of a German M1 money demand function are investigated, applying smooth transition regression techniques. Using seasonally unadjusted quarterly data from 1961(1) to 1990(2) it is found that the money demand equation considered is both linear and stable. After extending the sampling period until 1995(4) a clear structural instability due to the monetary unification on 1 July 1990 is found and subsequently modelled. A non-linear specification for the extended period is presented and discussed.