As part of its monetary policy strategy, the European Central Bank has formulated a reference value for M3 growth. A pre-requisite for the use of a reference value for M3 growth is the existence of a stable demand function for that aggregate. However, a large empirical literature has emerged showing that, beginning in 2001, essentially all euro area M3 demand functions have exhibited instability. This paper argues that a proper understanding of the determination of money requires a portfolio analysis where the demand for broad money is seen as just one element in the wealth portfolio. Under this framework, wealth is the variable that constitutes the total budget constraint on the holdings of assets, including money, and changes in equity prices are a key transmission channel of monetary policy. Understanding money behaviour thus requires good data on euro area wealth which at present do not exist. Our basic premise is that there is a stable demand-for-money function but that the models that have been used until now to estimate euro area money-demand are not well-specified because they do not include a measure of wealth. Using two empirical methodologies - - a co-integrated vector equilibrium correction (VEC) approach and a time-varying coefficient (TVC) approach - - we find that a demand-for-money function that includes wealth is stable. The upshot of our findings is that M3 behaviour continues to provide useful information about medium-term developments on inflation.
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Paper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number
08/9.
Length: Date of creation: Apr 2008 Date of revision: Handle: RePEc:lec:leecon:08/9
Contact details of provider: Postal: Department of Economics University of Leicester, University Road. Leicester. LE1 7RH. UK Phone: +44 (0)116 252 2887 Fax: +44 (0)116 252 2908 Email: Web page: http://www.le.ac.uk/economics/
Find related papers by JEL classification: C20 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - General E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
M. Hashem Pesaran & Yongcheol Shin, 2002.
"Long-Run Structural Modelling,"
Econometric Reviews,
Taylor and Francis Journals, vol. 21(1), pages 49-87.
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