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Money As An Inflation Indicator In Chile: Does P* Still Work?

  • Tobias Broer
  • Rodrigo Caputo

This paper analyses the information content of monetary aggregates for inflation in Chile. In particular, we adopt the P* framework that separates the effect of an estimated money overhang from those of the output gap. We use two variants of the model, the original Hallman et al (1991), and Gerlach and Svensson (2003), that conditions on an inflation target. We estimate both models for 6 different monetary aggregates, and 2 alternative estimates of equilibrium velocity. We find that over the estimation period, deviations of velocity from its equilibrium have significant effects on inflation, across models and definitions of the money gap, and for both narrow and broad money. The usual Chilean aggregate M1A, although it has some indicator properties, is outperformed by other money aggregates, first of all cash in the hands of the public, and a broad money aggregate containing time and foreign currency deposits. However, out-of sample forecasts show that over the recent past, most money gaps do not improve inflation forecasts. Also, inflation forecasts from broad and narrow money aggregates diverge in opposite directions in recent years, reflecting the estimated gaps that are large both for M1A and broader definitions of money, but opposite in sign. This finding puts a question mark behind the stability of money demand in recent times of stable and low inflation.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 293.

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Date of creation: Dec 2004
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Handle: RePEc:chb:bcchwp:293
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  1. Svensson, L.E.O., 1999. "Does the P* Model Provide any Rationale for Monetary Targeting," Papers 671, Stockholm - International Economic Studies.
  2. Lars E.O. Svensson & Stefan Gerlach, 2001. "Money and inflation in the Euro Area: A case for monetary indicators?," BIS Working Papers 98, Bank for International Settlements.
  3. Peter C.B. Phillips & Mico Loretan, 1989. "Estimating Long Run Economic Equilibria," Cowles Foundation Discussion Papers 928, Cowles Foundation for Research in Economics, Yale University.
  4. Jorge Restrepo L., 2002. "Demanda de Dinero para Transacciones en Chile," Notas de Investigación Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 5(3), pages 95-104, December.
  5. Hallman, Jeffrey J & Porter, Richard D & Small, David H, 1991. "Is the Price Level Tied to the M2 Monetary Aggregate in the Long Run?," American Economic Review, American Economic Association, vol. 81(4), pages 841-58, September.
  6. Mussa, Michael, 1981. "Sticky Prices and Disequilibrium Adjustment in a Rational Model of the Inflationary Process," American Economic Review, American Economic Association, vol. 71(5), pages 1020-27, December.
  7. McCallum, Bennett T, 1980. "Rational Expectations and Macroeconomic Stabilization Policy: An Overview," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 12(4), pages 716-46, November.
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