Interest in monetary aggregates extending beyond national borders has been stimulated by the agreement reached by European Community (EC) countries at Maastricht in December 1991 to proceed to monetary union (EMU). The eventual achievement of EMU would naturally lead to the use of monetary indicators for the monetary union as a whole; the properties of an aggregate of national money demands are therefore of interest. A European central bank would need credible targets, and it is possible that cross-country monetary aggregates could provide the basis for monetary targeting. Moreover, the presumption that money demands in EC countries will be increasingly affected by currency substitution as financial integration proceeds, and the likelihood that economic activity and inflation are influenced by monetary conditions in other countries, also make it natural to consider cross-country monetary aggregates.
The paper considers two empirical questions for a core group of countries that have maintained their parities against the deutsche mark for an extended period of time: 1) whether demand for core-ERM M3 is more stable and predictable than national demands for money; and 2) whether monetary aggregates in other countries are useful indicators of future trends in inflation. The paper focuses on aggregating German data with those of France, Belgium, Luxembourg, the Netherlands, and Denmark, which have low inflation, and which have not realigned relative to the deutsche mark since at least January 1987--in the case of the Netherlands, since March 1983. The Belgium-Luxembourg monetary union and the Netherlands have also limited fluctuations of their currencies relative to the deutsche mark to a greater extent than required by the narrow ERM band.
The conclusion of the preliminary work reported in the paper is that there appears to be some evidence of a long-run money demand relationship for a core group of ERM countries between M3, economic activity, the price level, and either domestic or German interest rates. Such a long-run relationship, together with an estimated dynamic adjustment equation, might be a useful indicator when formulating German, and ERM, monetary policy in the transition to monetary union. Though currency substitution is not tested directly, the stability of the core-ERM aggregate may reflect this phenomenon to some extent; currency substitution may also have caused the apparent lack of robustness of national money demands.
The results also show that core-ERM money has predictive power for German inflation. This is important because it suggests that other countries’ money supplies may also be useful indicators in achieving German domestic targets. One aspect of the results that is particularly suggestive is that estimates of core-group money demand and tests of linear feedback are stronger for the period from 1983 onward, when exchange-rate fluctuations within the core group were limited. This implies that as a zone of exchange rate stability is maintained, at least among a small group of countries, and as European integration proceeds, the relevance of core-group ERM money may increase.