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A Portfolio Balance Approach to Euro-Area Money Demand in a Time-Varying Environment

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  • Stephen G Hall

    ()

  • George Hondroyiannis
  • P.A.V.B. Swamy
  • George S. Tavlas

    ()

Abstract

As part of its monetary policy strategy, the European Central Bank has formulated a reference value for M3 growth. A pre-requisite for the use of a reference value for M3 growth is the existence of a stable demand function for that aggregate. However, a large empirical literature has emerged showing that, beginning in 2001, essentially all euro area M3 demand functions have exhibited instability. This paper argues that a proper understanding of the determination of money requires a portfolio analysis where the demand for broad money is seen as just one element in the wealth portfolio. Under this framework, wealth is the variable that constitutes the total budget constraint on the holdings of assets, including money, and changes in equity prices are a key transmission channel of monetary policy. Understanding money behaviour thus requires good data on euro area wealth which at present do not exist. Our basic premise is that there is a stable demand-for-money function but that the models that have been used until now to estimate euro area money-demand are not well-specified because they do not include a measure of wealth. Using two empirical methodologies - - a co-integrated vector equilibrium correction (VEC) approach and a time-varying coefficient (TVC) approach - - we find that a demand-for-money function that includes wealth is stable. The upshot of our findings is that M3 behaviour continues to provide useful information about medium-term developments on inflation.

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Bibliographic Info

Paper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number 08/9.

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Date of creation: Apr 2008
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Handle: RePEc:lec:leecon:08/9

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Keywords: Money demand; VEC; time varying coefficient estimation; Euro area;

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References

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  1. P. Swamy & George Tavlas, 2005. "Theoretical conditions under which monetary policies are effective and practical obstacles to their verification," Economic Theory, Springer, Springer, vol. 25(4), pages 999-1005, 06.
  2. David Cobham, 1996. "Causes and Effects of the European Monetary Crises of 1992-93," Journal of Common Market Studies, Wiley Blackwell, Wiley Blackwell, vol. 34(4), pages 585-604, December.
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  4. Joaquim Vieira Ferreira Levy & Alessandro Calza & Dieter Gerdesmeier, 2001. "Euro Area Money Demand," IMF Working Papers 01/179, International Monetary Fund.
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  7. P. Swamy & George Tavlas, 2007. "The New Keynesian Phillips Curve and Inflation Expectations: Re-Specification and Interpretation," Economic Theory, Springer, Springer, vol. 31(2), pages 293-306, May.
  8. P.A.V.B. Swamy & George S. Tavlas, 1993. "Random coefficient models: theory and applications," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 93-14, Board of Governors of the Federal Reserve System (U.S.).
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Cited by:
  1. Ansgar Belke & Robert Czudaj, 2010. "Is Euro Area Money Demand (Still) Stable? – Cointegrated VAR versus Single Equation Techniques," Ruhr Economic Papers, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen 0171, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.
  2. Hall, Stephen G. & Kenjegaliev, Amangeldi & Swamy, P.A.V.B. & Tavlas, George S., 2013. "Measuring currency pressures: The cases of the Japanese yen, the Chinese yuan, and the UK pound," Journal of the Japanese and International Economies, Elsevier, vol. 29(C), pages 1-20.
  3. Sophia Lazaretou, 2009. "Money supply and Greek history monetary statistics: definition, construction, sources and data," Working Papers, Bank of Greece 105, Bank of Greece.
  4. Jawadi, Fredj & Sousa, Ricardo M., 2013. "Money demand in the euro area, the US and the UK: Assessing the role of nonlinearity," Economic Modelling, Elsevier, Elsevier, vol. 32(C), pages 507-515.
  5. Stephen Hall & P.A.V.B. Swamy & George S. Tavlas, 2012. "Milton Friedman, the Demand for Money and the ECB’s Monetary-Policy Strategy," Discussion Papers in Economics, Department of Economics, University of Leicester 12/05, Department of Economics, University of Leicester.
  6. Peter Bernholz, 2008. "Government Bankruptcy of Balkan Nations and their Consequences for Money and Inflation before 1914: A Comparative Analysis," Working Papers, Bank of Greece 74, Bank of Greece.
  7. Stephan Barisitz, 2008. "Banking Transformation (1989 - 2006) in Central and Eastern Europe - With Special Reference to Balkans," Working Papers, Bank of Greece 78, Bank of Greece.

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