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Money Demand and the Role of Monetary Indicators in Forecasting Euro Area Inflation

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  • Christian Dreger
  • Jürgen Wolters

Abstract

This paper examines the forecasting performance of a broad monetary aggregate (M3) in predicting euro area inflation. Excess liquidity is measured as the difference between the actual money stock and its fundamental value, the latter determined by a money demand function. The out-of sample forecasting performance is compared to widely used alternatives, such as the term structure of interest rates. The results indicate that the evolution of M3 is still in line with money demand even in the period of the financial and economic crisis. Monetary indicators are useful to predict inflation at the longer horizons, especially if the forecasting equations are based on measures of excess liquidity. Due to the stable link between money and inflation, central banks should implement exit strategies from the current policy path, as soon as the financial conditions are expected to return to normality.

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Paper provided by DIW Berlin, German Institute for Economic Research in its series Discussion Papers of DIW Berlin with number 1064.

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Length: 27 p.
Date of creation: 2010
Date of revision:
Handle: RePEc:diw:diwwpp:dp1064

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Keywords: Money demand; excess liquidity; money and inflation;

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Cited by:
  1. Christian Dreger & Jürgen Wolters, 2011. "Money and Inflation in the Euro Area during the Financial Crisis," Discussion Papers of DIW Berlin, DIW Berlin, German Institute for Economic Research 1131, DIW Berlin, German Institute for Economic Research.
  2. De Santis, Roberto A & Favero, Carlo A. & Roffia, Barbara, 2012. "Euro Area Money Demand and International Portfolio Allocation: A Contribution to Assessing Risks to Price Stability," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8957, C.E.P.R. Discussion Papers.
  3. Matteo Barigozzi & Antonio Conti, 2013. "On the Stability of Euro Area Money Demand and its Implications for Monetary Policy," LEM Papers Series, Laboratory of Economics and Management (LEM), Sant'Anna School of Advanced Studies, Pisa, Italy 2013/11, Laboratory of Economics and Management (LEM), Sant'Anna School of Advanced Studies, Pisa, Italy.
  4. Christian Dreger & Jürgen Wolters, 2014. "Unconventional Monetary Policy and Money Demand," Discussion Papers of DIW Berlin, DIW Berlin, German Institute for Economic Research 1382, DIW Berlin, German Institute for Economic Research.

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