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

  • Stephen G Hall


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


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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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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  1. Swamy, P A V B & Tavlas, George S, 1995. " Random Coefficient Models: Theory and Applications," Journal of Economic Surveys, Wiley Blackwell, vol. 9(2), pages 165-96, June.
  2. George S. Tavlas & P.A.V.B. Swamy, 2006. "The New Keynesian Phillips Curve and Inflation Expectations: Re-Specification and Interpretation," Working Papers 34, Bank of Greece.
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  5. P. Swamy & George Tavlas, 2005. "Theoretical conditions under which monetary policies are effective and practical obstacles to their verification," Economic Theory, Springer, vol. 25(4), pages 999-1005, 06.
  6. David Cobham, 1996. "Causes and Effects of the European Monetary Crises of 1992-93," Journal of Common Market Studies, Wiley Blackwell, vol. 34(4), pages 585-604, December.
  7. Joaquim Vieira Ferreira Levy & Alessandro Calza & Dieter Gerdesmeier, 2001. "Euro Area Money Demand: Measuring the Opportunity Costs Appropriately," IMF Working Papers 01/179, International Monetary Fund.
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