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The Functional Form Of The Demand For Euro Area M1

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Author Info
Livio Stracca (European Central Bank, Directorate Monetary Policy)

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Abstract

A remarkable development seen in recent years is the pronounced decline in euro area M1 velocity vis-ý-vis a moderate decline in short-term interest rates, which represent the most natural opportunity cost for M1, suggesting an increase in the interest rate elasticity of M1 demand. In fact, estimating a theoretically plausible and stable demand function for M1 in the euro area is possible if a functional form of money demand allowing for an interest rate elasticity decreasing in size with the level of the interest rate is imposed. This finding would apparently suggest that the decline in inflation and nominal interest rates in Europe experienced in the run-up to the euro should have 'naturally' brought about an increased degree of preference for liquidity without any fundamental change in agents' preferences. To test the validity of this conclusion, a time-varying parameters model is estimated through a Kalman filter on the level of real M1, which is able to test simultaneously the stability of the parameters and the functional form of the demand for euro area M1. In this case, results clearly suggest the double-log function to be very close to the true 'deep' functional form of M1 demand in the euro area, consistent with the findings of Chadha, Haldane and Janssen for the UK and of Lucas for the USA. At the same time, there is evidence of an increased interest rate elasticity in M1 demand in the most recent years, presumably associated with the transition to the new environment prevailing from the start of Stage Three of European Monetary Union. Copyright 2003 Blackwell Publishing Ltd and The Victoria University of Manchester.

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Article provided by University of Manchester in its journal The Manchester School.

Volume (Year): 71 (2003)
Issue (Month): 2 (03)
Pages: 172-204
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Handle: RePEc:bla:manchs:v:71:y:2003:i:2:p:172-204

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  1. Gunter Coenen & Volker Wieland, 2000. "A Small Estimated Euro-Area Model with Rational Expectations and Nominal Rigidities," Econometric Society World Congress 2000 Contributed Papers 1284, Econometric Society. [Downloadable!]
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  2. Orphanides, Athanasios & Wieland, Volker, 2000. "Inflation zone targeting," European Economic Review, Elsevier, vol. 44(7), pages 1351-1387, June. [Downloadable!] (restricted)
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  3. Ignazio Angeloni & Luca Dedola, 1999. "From the ERM to the euro: new evidence on economic and policy convergence among EU countries," Working Paper Series 4, European Central Bank. [Downloadable!]
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  4. Carlo Monticelli & Oreste Tristani, 1999. "What does the single monetary policy do? A SVAR benchmark for the European Central Bank," Working Paper Series 2, European Central Bank. [Downloadable!]
  5. Francesco P. Mongelli & Oliver De Bandt, 2000. "Convergence of fiscal policies in the Euro area," Working Paper Series 20, European Central Bank. [Downloadable!]
  6. Gabriel Fagan & Jérôme Henry & Ricardo Mestre, 2001. "An area-wide model (AWM) for the euro area," Working Paper Series 42, European Central Bank. [Downloadable!]
  7. Olivier de Bandt & E Philip Davis, 1999. "A cross-country comparison of market structures in European banking," Working Paper Series 7, European Central Bank. [Downloadable!]
  8. de Bandt, Olivier & Hartmann, Philipp, 2000. "Systemic Risk: A Survey," CEPR Discussion Papers 2634, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  1. Carsten Detken & Vincent Brousseau, 2001. "Monetary policy and fears of financial instability," Working Paper Series 089, European Central Bank. [Downloadable!]
  2. Jean-Bernard Chatelain & Andrea Generale & Ignacio Hernando & Philip Vermeulen & Ulf von Kalckreuth, 2001. "Firm investment and monetary policy transmission in the Euro area," Working Paper Series 112, European Central Bank. [Downloadable!]
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  3. Michael Ehrmann & Frank Smets, 2001. "Uncertain potential output: implications for monetary policy," Working Paper Series 059, European Central Bank. [Downloadable!]
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  4. Alessandro Calza & Andrea Zaghini, 2008. "Nonlinearities in the dynamics of the euro area demand for M1," Temi di discussione (Economic working papers) 690, Bank of Italy, Economic Research Department. [Downloadable!]
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  5. Alessandro Calza & Andrea Zaghini, 2006. "Non-linear dynamics in the euro area demand for M1," Working Paper Series 592, European Central Bank. [Downloadable!]
  6. Dumitru, Ionut, 2002. "Money Demand in Romania," MPRA Paper 10629, University Library of Munich, Germany. [Downloadable!]
  7. Reimers, Hans-Eggert, 2002. "Analysing Divisia Aggregates for the Euro Area," Discussion Paper Series 1: Economic Studies 2002,13, Deutsche Bundesbank, Research Centre. [Downloadable!]
  8. Stefan Straetmans & Casper G. De Vries & Philipp Hartmann, 2001. "Asset market linkages in crisis periods," Working Paper Series 071, European Central Bank. [Downloadable!]
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  9. Ingrid Groessl & Ulrich Fritsche, 2006. "The Store-of-Value-Function of Money as a Component of Household Risk Management," Macroeconomics and Finance Series 200606, Hamburg University, Department Wirtschaft und Politik. [Downloadable!]
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  10. Diego Rodriguez Palenzuela & Gonzalo Camba-Mendez & Juan Angel Garcia, 2003. "Relevant economic issues concerning the optimal rate of inflation," Working Paper Series 278, European Central Bank. [Downloadable!]
  11. Livio Stracca, 2001. "Does liquidity matter? Properties of the synthetic divisia monetary aggregate in the Euro area," Working Paper Series 079, European Central Bank. [Downloadable!]
  12. Eugenio Gaiotti & Andrea Generale, 2001. "Does monetary policy have asymmetric effects? A look at the investment decisions of Italian firms," Working Paper Series 110, European Central Bank. [Downloadable!]
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  13. Gonzalo Camba-Mendez & George Kapetanios, 2001. "Spectral based methods to identify common trends and common cycles," Working Paper Series 062, European Central Bank. [Downloadable!]
  14. Fidrmuc, Jarko, 2006. "Money Demand and Disinflation in Selected CEECs during the Accession to the EU," Discussion Papers in Economics 1232, University of Munich, Department of Economics. [Downloadable!]
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  15. Andreas Worms, 2001. "The reaction of bank lending to monetary policy measures in Germany," Working Paper Series 096, European Central Bank. [Downloadable!]
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