Central Bank Credibility and Income Velocity in a Monetary Union

The income velocity of circulation has been subject to a trend decline in all the member states of the European Monetary Union since its inception. In this paper, we propose an explanation for this in terms of a measure of the ECB’s inflation fighting credibility. This credibility gain variable, which is derived in this paper, is based on the ECB’s performance in maintaining price stability relative to the respective member states’ inflation experiences from the legacy monetaryinflation regimes of the past. Our empirical analysis reveals that this credibility gain variable has a highly significant and sizeable impact on income velocity in member states. On average across member states, a one per cent increase in credibility gain, according to our measure, leads to a decreace in income velocity of half a per cent. The model and results presented suggest that the ECB should, in formulating the second pillar of its monetary policy strategy, factor in its own price stability credibility. Our results also imply that, if inflation fighting credibility is lost temporarily, it is hugely important to re-establish it as soon as possible.