The resurgence of interest in money demand functions in single countries over the last couple of years (see, for example, Hall, Henry, and Wilcox (1990), Johansen and Juselius (1990), and Muscatelli and Papi (1990)), has been accompanied by a growing interest in the extent to which a similar approach can be taken in respect of the demand for a European aggregate money supply (see Bekx and Tullio (1987), Angeloni, Cottarelli, and Levy (1991), and Monticelli and Strauss-Kahn (1991)). “Economic and Monetary Integration and the Aggregate Demand for Money in the EMS,” by Kremers and Lane (1990) was one of the first papers to suggest that a stable exchange rate mechanism (ERM)-wide money demand function does indeed exist. In view of the important policy implications that could follow from the existence of such a stable function, it is essential that any results from which this conclusion might be drawn should be subject to rigorous testing—even if this means using the benefit of “hindsight” and data not available at the time of the original investigation.
Kremers and Lane present an econometric model that explains the demand for ERM-wide narrow money in terms of income, interest rates, inflation, and exchange rates against the U.S. dollar, each of which is aggregated or averaged across countries as appropriate. On the basis of their results, the authors conclude that “even at the present stage of economic and monetary integration, a European central bank might be able to implement monetary control more effectively than the individual national central banks” (p. 777). This note tests the robustness of Kremers and Lane’s results by attempting to replicate them, with a view to subjecting them to alternative statistical tests as set out in MacKinnon (1990) and by testing their validity over an updated estimation period.
The broad conclusion is that while the model has some validity within the period over which h was estimated (1978 to 1987), it breaks down when asked to explain the demand for money over an updated period (1978 to 1990).
Angeloni, Ignazio, Carlo Cottarelli, and Aviram Levy, “Monetary Policy in Stage Two of EMU” (unpublished; London: Centre for Economic Policy Research, January 1991).
Bekx, P., and Giusepe Tullio, “The European Monetary System and the Determination of the DM-Dollar Exchange Rate” (unpublished; Brussels: Commission of the European Communities, May 1987).
Engle, Robert F., and C. W. J. Granger, “Co-integration and Error Correction: Representation, Estimation, and Testing,” Econometrica, Vol. 55 (March 1987), pp. 251–76.
Engle, Robert F., and B. Sam Yoo, “Cointegrated Economic Time Series: A Survey with New Results” (unpublished; San Diego: University of California, August 1989).
Hall, Steven G., S. G. B. Henry, and J. B. Wilcox, “The Long Run Determination of UK Monetary Aggregates,” in Economic Modelling at the Bank of England, ed. by S. G. B. Henry and K. D. Patterson (London; New York: Chapman and Hall, 1990).
Johansen, Soren, and Katarina Juselius, “Maximum Likelihood Estimation and Inference on Cointegration, with Applications to the Demand for Money,” Oxford Bulletin of Economics and Statistics, Vol. 52 (May 1990), pp. 169–210.
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)| false Johansen, Soren, and Katarina Juselius, “Maximum Likelihood Estimation and Inference on Cointegration, with Applications to the Demand for Money,” Oxford Bulletin of Economics and Statistics, Vol. 52( May 1990), pp. 169– 210. 10.1111/j.1468-0084.1990.mp52002003.x
Kremers, Jeroen J. M., and Timothy D. Lane, “Economic and Monetary Integration and the Aggregate Demand for Money in the EMS,” Staff Papers, International Monetary Fund, Vol. 27 (December 1990), pp. 777–805.
Monticelli, Carlo, and Marc-Olivier Strauss-Kahn, “European Integration and the Demand for Broad Money” (unpublished; Economic Unit of the Committee of Governors of EC Central Banks: Brussels, January 1991).
Muscatelli, Vito Antonio, and Luca Papi, “Cointegration, Financial Innovation and Modelling the Demand for Money in Italy,” The Manchester School of Economic and Social Studies, Vol. 58 (September 1990), pp. 242–59.
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)| false Muscatelli, Vito Antonio, and Luca Papi, “Cointegration, Financial Innovation and Modelling the Demand for Money in Italy,” The Manchester School of Economic and Social Studies, Vol. 58( September 1990), pp. 242– 59. 10.1111/j.1467-9957.1990.tb00421.x
Sargan, J. Dennis, and Alok Bhargava, “Testing Residuals from Least Squares Regression for Being Generated by the Gaussian Random Walk,” Econometrica, Vol. 15 (January 1983), pp. 153–74.
Stock, James H., “Asymptotic Properties of Least Squares Estimators of Cointegrating Vectors,” Econometrica, Vol. 55 (September 1987), pp. 1035–56.
David Barr is with the Bank of England. The views expressed here are his own and not necessarily those of the Bank of England.
Since these are statistically valid only if the equation contains only two variables, they are presented here solely as a guide.