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A panel data set for six countries (Czech Republic, Hungary, Poland, Romania, Slovakia and Slovenia) is used to estimate money demand with panel cointegration methods over the recent disinflation period. The basic money demand model is able to convincingly explain the long-run dynamics of M2 in the selected countries. However, money demand is found to have been significantly determined by the euro area interest rates and the exchange rate against the euro, which indicates possible instability of money demand functions in the Central and Eastern European countries. Therefore, direct inflation targeting is an appropriate monetary regime before the eventual adoption of the euro. [ABSTRACT FROM AUTHOR]

This paper examines currency substitution (CS) and the incentive for European monetary union. In the standard money demand study, interest rates are entered as the opportunity cost of holding money. Thus, if foreign interest rates enter significantly in a standard money demand function, this is interpreted as evidence of CS. Since money services may be provided by either domestic or foreign money, the domestic money demand function includes both domestic and foreign variables. With no CS, the standard floating exchange rate scenario is one of a stable money demand function for each currency that is independent of external nominal shocks. Since the issue of CS is relevant for policy under floating exchange rates, the money demand functions will be estimated over the 1973-80 period. The key variables for testing the hypothesis of CS are the money quality or inflation uncertainty variables. Foreign money yields a pecuniary return only because of exchange rate changes. The money quality proxies suggest that there is substitutability between the pound and the franc in the British regression, the mark and all three foreign alternatives in the German regression, and the lira and the franc and mark in the Italian regression.