Does Money Matter for Inflation in the Euro Area?
We analyse the role of euro area M3 as an indicator for future inflation. We analyse the short and long run relationship between money growth and inflation in an error correction framework taking into account the output gap and short and long term interest rates. We find robust cointegration between money growth and inflation. In the long run, shocks in M3-growth account for 33 percent to 40 percent of the inflation forecast error variance. We find evidence for significantly different dynamics of interest rates at the end of the seventies and beginning of the eighties. The dynamic relationship between money growth and inflation, however, remains stable over time, which implies that the deviation of real money growth from its long run average is a good indicator for future inflation acceleration or deceleration. Of course, this finding confirms the usefulness of monetary analysis in the ECB policy setting process and indicates that an M3-growth rate of slightly above 5% is compatible with a nonaccelerating average rate of inflation of 2%.
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|Date of creation:||2005|
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