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Capturing the Link between M3 Growth and Inflation in the Euro Area – An Econometric Model to Produce Conditional Inflation Forecasts

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Abstract

In this paper, we capture the link between M3 growth and inflation with a vector error correction model. The analysis also includes the 10-year government bond yield, the three-month EURIBOR interest rate and GDP. The long-run link between M3 growth and inflation is observable in the raw data. Over the years 1980–2006, we find that M3 growth and inflation are cointegrated, which means that deviations from long-term average real money growth lead to mean-reverting adjustment processes to restore the average level of real money growth. The full effect of an unexpected monetary shock thus materializes over time in the level of inflation, after a transitory period during which GDP and interest rates have been affected as well. Out-of-sample yearly conditional inflation forecasts are produced from 2001 to 2006 which are compared to Eurosystem staff projections. Qualitatively, the monetary model predicts future inflation rates which are consistent with the ECB’s assessment of future inflation prospects.

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  • Sylvia Kaufmann, 2007. "Capturing the Link between M3 Growth and Inflation in the Euro Area – An Econometric Model to Produce Conditional Inflation Forecasts," Monetary Policy & the Economy, Oesterreichische Nationalbank (Austrian Central Bank), issue 2, pages 93-108.
    • Handle: RePEc:onb:oenbmp:y:2007:i:2:b:5
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    1. Kulaksizoglu, Tamer & Kulaksizoglu, Sebnem, 2009. "The U.S. Excess Money Growth and Inflation Relation in the Long-Run: A Nonlinear Analysis," MPRA Paper 23780, University Library of Munich, Germany.

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    More about this item

    Keywords

    M3; monetary analysis; inflation forecasts.;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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