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The author is currently at the Directorate General for Economic and Financial Affairs of the European Commission. The views expressed in this paper are the author’s and do not represent those of the EU Commission. The paper has benefited from comments by Michael Artis, Anindya Banerjee, Bankim Chadha, Michael Deppler, Albert Jaeger, Guy Meredith, Kevin Ross, Alessandro Zanello, and excellent research assistance by Sergei Antoshin. Dieter Gerdesmeier and Barbara Roffia of the ECB, and Vincent Perilleux of the Central Bank of Belgium have also provided useful comments. Janet Bungay and Carole Dunne have provided excellent editorial assistance.
Angeloni, Gaspar, and Tristani (1999) provide a useful theoretical justification for the framework.
The main objective of the ECB as spelled out in its constitution is to maintain price stability. The Protocol (No. 18) (ex No. 3) on the Statute of the European System of Central Banks and of the European Central Bank (see, www.ecb.int) states that “In accordance with Article 105(1) (ex Article 105(1)) of this Treaty, the primary objective of the ESCB shall be to maintain price stability....”
A number of studies have confirmed the existence of stable money demand equations for the euro area (for example, Coenen and Vega, 1999; Brand and Cassola, 2000; Kontolemis, 2001; and Calza, Gerdesmeier, and Levy, 2001).
Clements, Kontolemis, and Levy (2001), in a different exercise, attempt to control for different reaction functions in measuring the effects of monetary policy on GDP and inflation.
This has been discussed also in a more recent survey paper prepared by the ECB (see Brand, Gerdesmeier, and Roffia, 2002).
According to estimates by the Deutsche Bundesbank, in the mid-1990s, 30-40 percent of all the DM banknotes were held abroad. Although estimates for other currencies are not available, it is certain that smaller quantities of other currencies may also be circulating outside the euro area(see Box 1, ECB Monthly Bulletin, September 2001, for a discussion).
A deterministic trend is not ideal for capturing the “true” data generating process, given that demand for euros outside the euro area may fluctuate considerably. However, it can be used as a good proxy for world GDP, for example, and may provide a more reliable estimate for M3 demand in the event of an idiosyncratic downturn in the euro area.
For expositional purposes we rearrange the estimated equation, which is based on a model that uses real money balances (m-p).
In this paper we avoid using the term “elasticity” since it has argued recently that in these VAR systems it is hard to interpret the coefficients of the long-run equation as “standard” elasticities (see in particular Johansen, 2002, and references therein.)
Using the trace statistic to test these hypotheses we find for (i) 26.7**, (ii) 27.62* for rank=0; and for (i) 6.55**, (ii) 6.55 for p<=l, and we therefore cannot reject the latter.
The long-term interest rate does not enter the long-run money demand function, suggesting perhaps that the inclusion of the short rate suffices as a measure of the opportunity cost of holding real money balances. A more detailed analysis of the measurement of the correct opportunity cost of holding money was presented in a recent paper by Calza, Gerdesmeier, and Levy (2001), which shows that a correctly measured proxy for this opportunity cost of M3 is highly correlated with the short-term interest rate.
The paper by Brand, Gerdesmeier, and Roffia (2002) provides a review of the existing money demand models published by the ECB.
Our reexamination of the model of Brand and Casola (2000) using the revised data revealed that this model did not perform well in terms of forecasting and stability of the estimated parameters. In particular, our statistical analysis rejects the specification proposed in that paper and finds that the coefficients in that model are not constant over time. This in fact is also confirmed in the recent paper by Brand, Gerdesmeier, and Roffia (2002) which reports a newly estimated version of their equation m − p = 1.32y − 2.4l, which is significantly different from their original equation given by, m − p = 1.32y − 0.6l. Brand, Gerdesmeier, and Roffia (2002) conclude that “Considering the uncertainty underlying these estimates, they can be considered to lie well within the range of estimates of this relationship provided in BC(2000)”
Using the trace statistic to test these hypotheses we find for (i) 145.4**, (ii) 151.2**, and (iii) 96.42** for rank=0; (i) 84.03**, (ii) 88.86**, and (iii) 63.29** for rank<=1; (i) 52.27**, (ii) 57.05**, and (iii) 33.97 for rank<=2; and we therefore cannot reject the latter.
Notice, that the trending behavior in the variables is captured by the unrestricted constant term that enters the VAR; this, as was explained earlier, induces a deterministic trend in levels.
For example, an alternative identification scheme for the second cointegrating relationship which assumed the GDP to be a function of the spread and inflation in the long-run, still produced a very similar money demand specification, or, (m − p) = y − 1.43s (more details are available upon request from the author).
The role of asset prices in the monetary transmission mechanism in the euro area is discussed at length in a recent paper by Cassola and Morana (2002). The important question whether monetary policy should respond to asset prices has been debated extensively recently, but it remains highly controversial (for example, Cecchetti and others, 2001, Bryan and others, 2002, and references therein.)
This is essentially the German DAX index through 1997 and an average of the DAX and CAC 50 subsequently. The correlation between these two series, and the wider euro area index, is rather high although such an index is not available for the entire period under consideration.
An alternative version of this, with asset prices treated as an exogenous variable, is discussed later on.
Notice that asset prices could also be a proxy for wealth in the euro area, and in that case the coefficient on that variable could be positive. However, stock ownership is not the biggest component of total wealth in the euro area (e.g., relative to real estate,) and the prices of the two series are not always highly correlated. Some cursory analysis shows that the response of money growth, to a shock in asset prices, is negative and appears to be statistically significant, thus corroborating with the assessment that this variable is negatively related to M3 growth.
These variables, which are simply estimated as the difference between the level of M3 and estimated money demand, are adjusted so that their mean is zero over the sample period.
It is also important to bear in mind that the large size of some of these monetary overhang measures, or error correction terms, does not necessarily translate to faster adjustment of M3 growth rates. The speed of adjustment to these disequilibria, which is very important for the overall dynamic adjustment of the system, could vary in these four systems.
The contemporaneous growth rate of Ps and two lags are included in each equation as well as the second cointegrated vector.
Adding oil prices does not correct for the under-prediction of the inflation rate in early 1999. This is due to the fact that the GDP deflator used in the empirical analysis, is less correlated with the price of oil, or the exchange rate, but related to (the core inflation rate) and hence other variables not included in this system (e.g., wages.)
This is defined as the number of quarters it takes to close half of the monetary overhang Obviously, the adjustment is faster in the beginning and slows down (in percentage terms) as the gap is closed.
Owing to currency substitution, individual country money demand equations could appear to be unstable and the residuals of these equations to be negatively correlated across countries.
Note first that this model also suggests that the speed of adjustment back to equilibrium is proportional to the size of the disequilibria. Hence, it is natural to observe fast (positive or negative) growth rates following a shock. These, however, do not call for a change in the monetary policy stance.
Davidson et al. (1978) is the classic reference on error correction models, and more recently, in a multivariate context, Johansen (1988a,b and 1995), Hendry (1995), Doornik and Hendry (1997), and references therein.
The matrix c=[c1 c2]’ and Dt=[1 t].