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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 threemonth 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.

Suggested Citation

  • 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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    References listed on IDEAS

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    1. Sylvia Kaufmann & Peter Kugler, 2005. "Expected Money Growth, Markov Trends and the Instability of Money Demand in the Euro Area," Working papers 2005/07, Faculty of Business and Economics - University of Basel.
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    3. G. Coenen & J.-L. Vega, 2001. "The demand for M3 in the euro area," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 16(6), pages 727-748.
    4. Chowdhury, Ibrahim & Hoffmann, Mathias & Schabert, Andreas, 2006. "Inflation dynamics and the cost channel of monetary transmission," European Economic Review, Elsevier, vol. 50(4), pages 995-1016, May.
    5. Carstensen, Kai, 2006. "Stock Market Downswing and the Stability of European Monetary Union Money Demand," Journal of Business & Economic Statistics, American Statistical Association, vol. 24, pages 395-402, October.
    6. Michael Woodford, 2008. "How Important Is Money in the Conduct of Monetary Policy?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(8), pages 1561-1598, December.
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    8. Carstensen, Kai, 2007. "Is core money growth a good and stable inflation predictor in the euro area?," Kiel Working Papers 1318, Kiel Institute for the World Economy (IfW).
    9. Milton Friedman, 1971. "A Theoretical Framework for Monetary Analysis," NBER Books, National Bureau of Economic Research, Inc, number frie71-1.
    10. Beck, Günter W. & Wieland, Volker, 2006. "Money in monetary policy design under uncertainty: The two-pillar Phillips curve versus ECB-style cross-checking," CFS Working Paper Series 2007/17, Center for Financial Studies (CFS).
    11. Bruggeman, Annick & Camba-Méndez, Gonzalo & Fischer, Björn & Sousa, João, 2005. "Structural filters for monetary analysis: the inflationary movements of money in the euro area," Working Paper Series 470, European Central Bank.
    12. Christian Dreger & Jürgen Wolters, 2006. "Investigating M3 Money Demand in the Euro Area: New Evidence Based on Standard Models," Discussion Papers of DIW Berlin 561, DIW Berlin, German Institute for Economic Research.
    13. Johansen, Soren, 1995. "Likelihood-Based Inference in Cointegrated Vector Autoregressive Models," OUP Catalogue, Oxford University Press, number 9780198774501.
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    Cited by:

    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.

    More about this item

    Keywords

    M3; monetary analysis; inflation forecasts.;

    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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