A modified Currency Demand Function and the Malaysian shadow economy: Evidence from ARDL bounds testing approach

Abstract Improved estimates of the Malaysian Shadow Economy (SE), illegal money and corrections to the magnitude of SE using the ARDL technique based on the modified Currency Demand Function Model (CDFM) from 1972 to 2012 are provided in this paper. This study rectifies the failure in previous studies to capture the positive and symmetric relationships between the demand for money and per capita income. The use of the scale of real GDP in the Modified CDFM is necessary methodologically to obtain an accurate estimation of SE. This study combines the demand rate of deposits with circulated money as dependent variable, which is more liquid and thus may end up in SE. It considers inequality of the velocity of money in both economies (SE and the formal economy). The variables of opportunity cost of using money in their ratio level rather than logarithm form are used in the modified CDFM. The size of the SE in Malaysia has been fluctuating and averaged around 42.53% of GDP.