Abstract
This Selected Issues paper analyzes euro area policies and discusses the implications of the 2007–08 financial sector turbulence for real economic activity. It examines the linkages between the financial and real sectors in the euro area. The paper discusses the European Central Bank’s (ECB) monetary analysis and the role of monetary aggregates in central banking, surveying the ongoing theoretical and empirical debate. The paper also describes the introduction of a “European Mandate” for financial sector authorities in the European Union (EU), a proposal that is under consideration by EU member states.
II. Revisiting the Ecb’s Monetary Analysis10
A. Introduction: the Continuing Debate on the “Monetary Pillar”
25. Money plays an important role in the European Central Bank’s (ECB’s) monetary policy strategy. According to the ECB, monetary analysis (formerly known as the “monetary pillar”) helps to guide the policy–making process of the Governing Council by providing information on “medium to long–term trends in inflation, given the close relationship between money and prices over extended horizons” (ECB, 2003, p. 79). It also serves as a communication device by stressing the ECB’s commitment to price stability. While a certain proximity to the monetary targeting framework of the German Bundesbank was intentional when the ECB announced its strategy, the central bank later made it clear that monetary analysis is neither its sole nor its most important guide to policy decisions. Today, the prime function of monetary analysis is to serve “as a means of cross–checking, from a medium to long–term perspective, the short to medium–term indications coming from economic analysis” (ECB 2003, p.87), which is a broad–based analysis of price developments in the short– to medium–run based on non–monetary indicators. Still, the continued explicit reliance on money to guide monetary policy is a distinguishing feature of the ECB’s framework compared to that of other central banks.
A stylized view of the role of money in the ECB’s monetary strategy.
Citation: IMF Staff Country Reports 2008, 263; 10.5089/9781451879896.002.A002
A stylized view of the role of money in the ECB’s monetary strategy.
Citation: IMF Staff Country Reports 2008, 263; 10.5089/9781451879896.002.A002
A stylized view of the role of money in the ECB’s monetary strategy.
Citation: IMF Staff Country Reports 2008, 263; 10.5089/9781451879896.002.A002
26. In practice, the implementation of the money‐based element of the ECB’s policy strategy has been challenging. In particular, the repeated surges of nominal M3 growth beyond the ECB’s reference value have made it increasingly difficult for outside observers to understand the transmission, however indirect and conditional, of monetary analysis into policy action.
ECB policy rate
(right axis) M3 growth continues to deviate widely from its reference value—without consistent impact on interest rates, posing challenges for ECB policy and communication.
Citation: IMF Staff Country Reports 2008, 263; 10.5089/9781451879896.002.A002
Source: European Central Bank.ECB policy rate
(right axis) M3 growth continues to deviate widely from its reference value—without consistent impact on interest rates, posing challenges for ECB policy and communication.
Citation: IMF Staff Country Reports 2008, 263; 10.5089/9781451879896.002.A002
Source: European Central Bank.ECB policy rate
(right axis) M3 growth continues to deviate widely from its reference value—without consistent impact on interest rates, posing challenges for ECB policy and communication.
Citation: IMF Staff Country Reports 2008, 263; 10.5089/9781451879896.002.A002
Source: European Central Bank.27. The problem is perhaps best understood in terms of the quantity theory of money. While a structural or causal relationship between money and inflation can be modeled in a number of ways (see Section B below), the quantity concept is most closely related to the ECB’s approach. The well–known concept states that, if prices were fully flexible, and the nominal money supply an exogenous policy variable, and its (income) velocity constant, any change in the nominal stock of money will result in a proportional change in prices. The problem in practice is that velocity is not constant and money is not fully exogenous. The ECB has made an impressive effort to identify and explain the various special factors clouding the informational content of the monetary indicator, working from a disaggregate analysis (such as identifying portfolio shifts). But the practical difficulties of ensuring consistency in judgmental M3 adjustment are hard to overcome, and, as a result, monetary analysis seems to have played an increasingly less important role—however indirect—as an indicator of ECB policy.
28. At the same time, academic economists are debating intensively the ECB’s monetary analysis. ECB watchers have criticized what they perceive as a breakdown in communication in the implementation of the “monetary pillar.” More fundamentally, recent theoretical research has cast doubt on the notion that monetary policy, almost by definition, needed to be based on a theoretical framework giving prominent role to monetary factors. Indeed, the standard New Keynesian dynamic general equilibrium (GE) model focuses almost exclusively on the interest rate channel of monetary policy, reducing the role of money to a unit of account. As a consequence, the underlying theoretical rationale of the “two pillar” approach has been questioned. Empirically, too, the case of a causal or even an informational role of money for inflation has been challenged. And while others disagree with these theoretical and empirical results, it is probably fair to say that there remains much debate about the role of money in monetary policy.
29. New IMF staff research and an extensive literature survey—summarized in Berger, Harjes, and Stavrev (2008)—concludes that monetary analysis should continue to be part of the ECB’s overall monetary strategy. However, it also finds a strong case for integrating monetary and economic analysis into a unified framework.
In particular, the following conclusions emerge:
While an exclusive focus on non–monetary factors alone may leave the ECB with an incomplete picture of the economy, treating monetary factors as a separate matter is a second–best solution. An analytical framework unifying monetary and non–monetary factors based on modern generalized GE models seems a promising way forward. Current standard models often do not include money but generalized models do, stressing, for instance, non–separability, and financial or informational frictions. This type of models can provide a consistent setup to study the joint impact and feedback between all determinants of inflation relevant for the ECB’s monetary strategy.
However, the role played by money in such a unified framework may be limited. This also seems to be the consensus within the literature, in particular, with regard to the non–separability and financial frictions. Similarly, from a forecasting viewpoint, money does contain relevant information for inflation but its value–added is often small. In addition, non–monetary models generally provide better inflation forecasts than money–based models.
Judgmental M3 adjustments, an important part of the ECB’s current monetary analysis, do little to improve the macroeconomic information content of money in real time. This is not to deny that disaggregate monitoring of financial sector activity may be very helpful with regard to financial stability issues.
Financial markets now widely ignore the signals from the monetary analysis and focus mostly on the economic analysis, thus missing part of the potential information set. Providing a clear, consistent, and unified narrative about the role of money in the economy seems essential to remedy this.
30. Overall, the current state of affairs could, over time, gradually detract from the credibility of the ECB’s monetary strategy and undermine potential benefits from improved monetary analysis in the future. While there is potentially much to be gained from further work on monetary analysis, it seems to be more productive to refine the monetary strategy in the context of a unified framework.
B. The Theoretical Case for Money
31. In the mainstream “cashless” New Keynesian GE model, money plays little or no role for inflation and is introduced, if at all, more or less as an afterthought (Clarida and others 1999, Woodford 2003). Central banks influence the economy through the interest rate and its impact on households’ consumption and investment decisions. And while interest rate control presupposes control of the money supply at a technical level, the central bank will supply money elastically at the set rate. If money is explicitly introduced into the model, this is mostly through the simple assumption that households have a desire for holding money in addition to (and separate from) their preferences for consumption and leisure. As a consequence, aggregate output and inflation remain independent of the money stock, and monetary developments are essentially an endogenous reflection of contemporaneous developments elsewhere in the economy.
32. The policy recommendation stemming from cashless GE models is that central banks would be well–advised to ignore monetary developments altogether. Conditioning monetary policy on monetary developments will do little to improve the central bank’s control over inflation. On the contrary, because money demand may be subject to shocks, conditioning interest rates on monetary developments could add unwanted volatility to the economy.
33. Those arguing in favor of a more prominent role of money dispute the lack of generality of the cashless benchmark, suggesting several ways to integrate monetary factors in a generalized model:
One fairly direct approach is to introduce non–separability in consumption and money in the household utility function. Nelson (2002) and Ireland (2004), among others, show that this will introduce a structural or causal link (reminiscent of the Pigou/Patinkin real balance effect of old) from monetary aggregates to the output gap and inflation because real balances now influence goods demand and the stochastic discount factor of price–setting firms.
Another idea is that financial frictions give money a structural role in the economy. The bank–lending channel emphasizes that monetary policy influences the real economy through bank loan supply, which depends to a large degree on the banks’ ability to draw demand deposits. Money matters in this regard because the availability of demand deposits is influenced by the supply of central bank liquidity (Bernanke and Gertler 1995, Diamond and Rajan 2006).
Another prominent argument is that of informational frictions. The general idea is that money may complement the information set of policy makers seeking to control inflation no matter whether it has a causal role to play in the economy or is purely endogenous. For instance, Meltzer (2001) and Nelson (2002) argue that money may be a superior index of monetary policy effects than the interest rate because money demand reflects a broad range of otherwise hard–to–observe asset prices. In addition, because money demand is also linked to output developments, money can serve as a real time indicator of real GDP developments, a variable the central bank observes only with a lag and lacking precision (Coenen and others 2005).11 As Nelson (2003) and Andrés and others (2007) show, monetary aggregates could even be a forward–looking indicator of GDP if money demand was subject to adjustment costs.
Finally, at a more technical level, a prominent role for money in monetary policy could be due to equilibrium indeterminacy in GE models (Christiano and others 2008). Already Sargent and Wallace (1975) argued that an interest rate rule may leave the economy’s price level indeterminate if the interest rate policy rule reacts to the history of exogenous disturbances only. McCallum (1981) pointed out that money could provide a solution. He stressed that the central bank could anchor the economy and avoid any unwanted volatility caused by multiple equilibria by conditioning the interest rate also on monetary developments.
34. The key insight from this discussion is that the case for a more prominent role for money in monetary policy can easily be made within one consistent analytical framework.12 While supporters of a strong role of money used to base their case on partial equilibrium models, the advent of generalized versions of the cashless New Keynesian GE model makes this less of a necessity.13 GE models, as Papademos (2006) notes, have “. . .the potential to incorporate in a substantive way the role and effects of money and credit in the monetary transmission mechanism.” They allow a fuller view of the role that money can play in the economy than any partial equilibrium model, including by capturing equilibrium feedbacks and by having model–consistent forward–looking expectations. Due to their firmer micro–foundations, most modern GE models are also less prone to the Lucas critique, that is, their underlying structure is generally independent from the policy regime.
35. There are various indications, however, that the role of money in such a unified framework may be small. McCallum (2001) stresses that non–separability effects tend to be small under plausible calibrations of the households’ utility function and much of the empirical literature supports this view both for the United States and the euro area (Ireland 2004, Andrés and others 2006). As Bernanke (2007) points out, the development of modern financial markets is likely to reduce the empirical relevance of the bank–lending channel, a point echoed by Eurosystem research (Angeloni and others, 2002). Also the extent of money’s informational function for monetary policy is still disputed.14 Finally, there is some debate whether equilibrium indeterminacy is a policy–relevant problem in GE models (Woodford 2003, McCallum 2003).
C. The Importance of Money for Inflation Forecasts
36. An empirical view on the role of money is interesting from a number of perspectives. Obviously, the relative weight allocated to monetary factors within a unified analytical framework is ultimately an empirical question, and one way to answer it is to identify the contribution that money can make to forecast inflation. In addition, a forward–looking policy maker may take the pragmatic position that money deserves attention if it proves helpful in forecasting inflation, no matter the precise theoretical (structural and/or informational) channels through which this occurs.
37. The picture emerging from the empirical literature so far is fairly mixed, however. A number of studies suggest that the indicator properties of money for inflation may be limited—either because money–based models do not perform well in a cross–country framework or because money is strongly outperformed by other indicators. For example, results in Roffia and Zaghini (2007) and de Grauwe and Polan (2005) question whether the often–repeated stylized fact that high money growth is followed by high inflation still applies to low–inflation, industrial regions such as the euro area. And OECD (2007) reports results from an euro area inflation forecasting “horserace” between alternative time–series models, suggesting that money played a prominent role only up to 2000, while after 2000 non–monetary models were better predictors of inflation.
38. In contrast, other strands in the literature suggests that money continues to be helpful for euro–area inflation forecasts. For example, the Bundesbank (2005) and Assenmacher–Wesche and Gerlach (2006a, 2006b) stress the usefulness of single–equation partial–equilibrium approaches featuring money. Other studies report that money helps to forecast inflation in more encompassing empirical models (e.g., Nicoletti–Altimari 2001, Scharnagl and Schumacher 2007, Hofmann 2008), even tough the size of this improvement is sometimes found to be very small once other determinants of inflation are taken into account (Berger and österholm 2008a). Interestingly, the last result seems not to be an artifact of the particularities of the euro area but extends to U.S. data (Berger and österholm 2008b).
39. Several factors explain these widely differing results, with important implications for any systematic approach to evaluating the information content of money in forecasting inflation. One factor is sample selection. D’Agostino and others (2006) make the point that the predictability of macroeconomic variables in general may have been lowered as macroeconomic volatility declined during the so–called great moderation. Another factor is given by differences in the empirical approach, where most of the literature focuses on either a single model or all–out horserace across a wide range of unrelated models instead of a comparison of related (or nested) model with and without money. Finally, as for instance Galí-and others (2004) warn, establishing a causal or forward–looking informational role for money requires the careful use of structural econometric approaches.15
40. Following these arguments, recent IMF research provides a systematic analysis of the information content of money for inflation in the euro area. Berger and Stavrev (2008) compare the simulated out–of–sample inflation forecasting performance of models with and without money for the period 2000–2007 for a number of typical model classes. These classes include, on the empirical side, vector autoregressive (VAR) and general dynamic factor models (GDFM) and, on the structural side, both partial and general equilibrium approaches—among others. The within–class comparison is based on the out–of–sample root mean square error (RMSE) at forecasting horizons of one, four, eight, and twelve quarters ahead.16 A lower RMSE implies better forecasting accuracy.
Several results emerge.17
Money helps the inflation forecasting performance of a number of models. A particularly interesting result is that the money– enhanced New Keynesian GE models outperform the cashless baseline model across all forecasting horizons, which supports both a structural and informational role of money for inflation. Yet, the improvement in terms of RMSE reduction from adding money averages only 0.3 percentage points of inflation. The drop in RMSEs from adding money for some of the empirical models are of a similar magnitude—in particular for the VAR models that, not unlike the GE approaches, allow some feedback between money and inflation. However, in other empirical model classes, such as the General Dynamic Factor Models (GDFM), introducing money produces miniscule RMSE reductions, and money largely fails to improve the forecasting accuracy of partial equilibrium models.
Comparing the performance of the money–based approaches across the various model classes, there seems to be a “u–shaped” relationship between the degree of their theoretical underpinnings and their forecasting performance: the best empirical models with money (in particular the VAR model) and the best GE model with money do better than the best partial equilibrium models. A corollary of this is that the information content of money may be best captured by a more explicit modeling of the underlying general equilibrium structure of the money–inflation relationship.
That said, the quantitative importance of money for inflation forecasting should not be overrated. As Berger and Stavrev (2008) stress, not only is the improvement from adding money often small, there is also evidence that some of the models eschewing money perform better overall. While the quantitative advantage of the moneyless models is not always large, the finding still puts the role of money into perspective.
Standard New Keynesian GE model without money
The marginal contribution of money to euro area inflation forecasting accuracy is positive but often small. This holds for many classes of empirical as well as theory-based, structural models (displayed here).
Citation: IMF Staff Country Reports 2008, 263; 10.5089/9781451879896.002.A002
Sources: Eurostat, IFS, Haver analytics, and IMF staff calculations.Standard New Keynesian GE model without money
The marginal contribution of money to euro area inflation forecasting accuracy is positive but often small. This holds for many classes of empirical as well as theory-based, structural models (displayed here).
Citation: IMF Staff Country Reports 2008, 263; 10.5089/9781451879896.002.A002
Sources: Eurostat, IFS, Haver analytics, and IMF staff calculations.Standard New Keynesian GE model without money
The marginal contribution of money to euro area inflation forecasting accuracy is positive but often small. This holds for many classes of empirical as well as theory-based, structural models (displayed here).
Citation: IMF Staff Country Reports 2008, 263; 10.5089/9781451879896.002.A002
Sources: Eurostat, IFS, Haver analytics, and IMF staff calculations.41. The conclusion emerging from the empirical analysis points in the same general direction as the theoretical considerations in Section B. There is evidence that a central bank interested in forecasting/assessing future inflation should take monetary factors into account, but this is best done in a framework encompassing also non–monetary factors, and the relative role played by money within such a setup is likely to be small.
D. The Disaggregate Perspective: Monetary Analysis to Look Behind M3
42. From the beginning, the ECB’s monetary analysis encompassed both a macroeconomic and a disaggregate (or more micro–oriented) perspective. The macroeconomic part of the analysis is implemented predominantly through a comparison of annual nominal M3 growth with a reference value, which is to reflect medium– to long–term monetary developments in line with the ECB’s goal of price stability. In addition, monetary analysis takes a disaggregate perspective, focusing on other indicators of liquidity developments than M3. For instance, the ECB carefully looks at various other monetary aggregates, private credit growth, as well as their counterparts in the aggregate balance sheet of monetary and financial institutions. As the ECB (1999) pointed out, the general idea of looking beyond M3 was to provide useful background information for the assessment of aggregate developments—for example, to help separate transitory from price–relevant movements in monetary conditions. In light of the post–9/11 volatility in financial markets, the ECB (2003) clarification of its monetary strategy put even greater emphasis on the disaggregate perspective.
43. In terms of the quantity theory, the problem with the ECB’s reference value stems from the fact that velocity is not constant—and this is where a disaggregate perspective could be helpful. In principle, a broadly defined money demand function may be able to account for velocity shifts while preserving the link between money and prices—but financial innovation and deregulation, technological progress, and financial integration have seriously undermined the empirical stability of models of velocity. As Friedman and Kuttner (1996) argue, the instability problem is especially severe in a modern financial system that offers an ever increasing number of financial assets, of which only an arbitrary subset will be included in a given definition of a monetary aggregate. For instance, euro–area M3 includes money market fund shares and other interest–bearing liquid assets that tend to increase in times of uncertainty as households aim to reduce the riskiness of their wealth portfolios. Such portfolio shifts can lead to higher M3 growth without necessarily being a harbinger of future goods price increases.18 As a consequence, the ECB has turned to disaggregate analysis and judgmental adjustments of M3 to preserve any information M3 growth might hold with regard to future price developments.
44. However, reliable real–time judgmental adjustments of monetary aggregates are difficult to achieve. In principle, one should expect such adjustments to be targeting obvious, unique, and relatively short–lived technical or behavioral phenomena that either do not require or do not allow structural modeling. But the factors underlying recent surges in M3 growth hardly satisfy these requirements. A case in point is the judgmental ECB correction for portfolio shifts in the euro area during 2001– 03. While ECB–identified portfolio shifts may indeed have been at the core of the M3 surge at the time, portfolio shifts did not explain much of the continued increase of M3 later on.
45. This leaves the question of what explains current M3 behavior and the associated decline in velocity. New financial innovation remains a leading candidate, and the ECB (2008) has looked at the role of securitization in this regard without coming to firm conclusions. With the disaggregate analysis providing little clues, the indicator quality of more or less permanent M3 growth above its reference value for inflation must seem doubtful even from the ECB’s perspective.
46. The discussion of securitization does, however, point to another possible function of a disaggregate perspective outside the realm of monetary strategy: disaggregate monetary analysis may provide useful input into the ECB’s assessment of financial stability. For example, the analysis of M3 counterparts may have provided some early warning signs of potential problems at euro–area banks when, starting in late 2006, the amount of securities issued by non–euro–area residents on German banks’ balance sheets suddenly rose sharply (Reischle 2007), perhaps because of an increasing inability to hold these securities in off–balance sheet vehicles due to rising funding pressure.
47. In sum, judgmental M3 adjustments, while an important part of the ECB’s current monetary analysis, seem to contribute little to the information content of money for future price developments in real time.
E. How Time Path Dependent Should the ECB’s Monetary Strategy Be?
48. At its inception, for the ECB as a new institution lacking a time–honed reputation, quickly establishing inflation–fighting credentials was critical, and linking its monetary strategy to that of the German Bundesbank proved helpful in this regard.19 Further urgency was added by the fact that the ECB stepped on the stage during a time of intensive structural change due to the introduction of the common currency and the ensuing uncertainties about typical shocks hitting the area, their propagation, and the monetary transmission mechanism (ECB 1999, Jaeger 2003). As Issing (2006, p.3) emphasizes, this type of uncertainty was among the arguments behind the ECB’s decision to stress the continuity of its policy framework with “the best performers of national central banks participating in monetary union, and especially with the Bundesbank.” This might have been helped by the fact that, in practice, the Bundesbank’ s monetary regime was itself fairly pragmatic, with an emphasis on communication rather than strict adherence to pre–set money growth targets.20
49. There is, however, reason to believe that loyalty to Bundesbank principles is no longer required on reputational grounds. Importantly, the ECB’s own reputation as an inflation–averse central bank is now well established, and its credibility does not rest predominantly on its monetary analysis. In fact, the subtle downgrading of the importance of money in the ECB’s monetary strategy after the 2003 monetary policy evaluation has markedly increased the difference between the ECB’s and the Bundesbank’s monetary strategy both in practice and principle. In addition, according to Berger and others (2006), over the years the ECB’s General Council has paid continuously less attention to monetary analysis in its words and deeds.21
50. As a consequence, the public and financial markets have ceased to attach much weight to the ECB’s monetary analysis. For example, Geraats and others (2008) point out that there remains much uncertainty regarding the role of the “monetary pillar” among ECB watchers, and many seem to focus more on the economic analysis. As other studies show, financial markets, too, have ceased attaching appreciable weight to the ECB Governing Council’s communications regarding monetary analysis (Lamla and Rupprecht 2006, Conrad and Lamla 2007). And according to recent ECB research, a broadly similar picture emerges from the financial market reaction to the monthly release of M3 data. ECB researchers Coffinet and Gouteron (2007) show that across interest rate horizons ranging from the very short– to the very long–run, the impact of M3 news (defined as data releases unexpected by the consensus forecast) has dramatically decreased over time, essentially becoming insignificant before or around the time of the ECB’s monetary strategy clarification in 2003.
51. In summary, there is little reason to expect that further changes in the role of monetary analysis within the ECB’s wider monetary strategy will have a detrimental impact on the ECB’s reputation as a price–stability oriented central bank among sophisticated investors and observers. In fact, the ECB reputation as an inflation–averse central bank is now well established, with, according to some research, long–run inflation expectations in the euro area more firmly anchored than in the United States (Beechey and others, 2008). Whether such changes might have an impact among the broader public in countries that prior to EMU also ran on a two–pillar system is a question that has not been addressed in the literature. But there are few reasons to believe that they would, provided the transition is well managed and takes place during a period of price stability. Therefore, from a communication viewpoint little seems to be lost and much might be gained if the present monetary policy framework would be recast into a unified approach. This would allow for a better presentation of the relative role of money for activity and inflation.
F. Summary
52. Money continues to play an important role in the ECB’s monetary strategy. This paper revisits the case for money, surveying the ongoing theoretical and empirical debate, including recent research by IMF staff. The key conclusion is that an exclusive focus on non–monetary factors alone may leave the ECB with an incomplete picture of the economy. However, treating monetary factors as a separate matter is a second–best solution. Instead, a general–equilibrium inspired analytical framework that merges the economic and monetary “pillars” of the ECB’s policy strategy appears the most promising way forward. The role played by monetary aggregates in such unified framework may be rather limited. However, an integrated framework would facilitate the presentation of policy decisions by providing a clearer narrative of the relative role of money in the interaction with other economic and financial sector variables, including asset prices, and their impact on consumer prices.
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This is a summary version of Berger, Harjes, and Stavrev (2008).
Along similar lines, Beck and Wieland (2007) argue that money could help policy makers suffering from a structural bias in their assessment of potential output.
The ECB for its part is currently carrying out research aimed at incorporating a richer financial sector into dynamic stochastic general equilibrium models, in order to study the role of financial variables in the conduct of monetary policy (see Papademos, 2006).
Prominent examples for partial–equilibrium arguments for a prominent role for money include the P–star model (Svensson, 2000 and Reynard, 2007) and the two–pillar Phillips curve (Gerlach, 2004). See Berger, Harjes, and Stavrev (2008) for a more extensive discussion.
There are a number of arguments suggesting limits to the informational role of money (see Berger, Harjes, and Stavrev, 2008, for additional discussion and references): (i) monetary aggregates are noisy because of money demand shocks, which reduce their informational usefulness; (ii) the inflationary consequences of a surge in money demand will depend on whether the underlying shock was demand– or productivity–driven; (iii) asset prices and various indicators of real activity can be observed directly without the help of money; and (iv) the quantitative relevance of the informational role of money in generalized GE models is not fully explored yet.
For instance, the cashless New Keynesian GE model can produce correlation between money growth and inflation, even though the model rejects a structural or informational role of money for inflation (Woodford 2007, 2008).
Such an exercise is akin to a Granger causality test in a multivariate environment (Ashley and others 1980).
See Berger and Stavrev (2008) for a detailed discussion.
Other hard–to–grasp factors influencing velocity include exchange rate fluctuations and the changing international role of the euro (Faruqee 2005).
Economic theory suggests that a central bank’s reputation can anchor private sector inflation expectations. Firms set relative prices under uncertainty about the future aggregate price level. In a repeated game the credibility of a central bank’s pledge to keep aggregate prices stable will depend on it own past actions or reputation, and thus a certain institutional time–path dependency can be an advantage.
See, among many, von Hagen (1999) and Posen (2000) for a similar view.
The finding is based on a content–analysis of the General Council’s introductory statements for its post– meeting press conferences. The analysis shows that the overall policy inclinations communicated by the General Council became increasingly less correlated with the monetary analysis contained in the statements. The same holds with regard to interest rate decisions.
