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Narrow Money and the Business Cycle: Theoretical aspects and euro area evdence

  • Claus Brand

    (European Central Bank)

  • Hans-Eggert Reimers

    (University of Technology, Business and Design Wismar)

  • Franz Seitz

    (University of Applied Sciences Amberg-Weiden)

This paper analyses the information content of M1 for euro area real GDP since the beginning of the 1980s. After a literature review on the empirical results in individual euro area countries we review some theoretical arguments why real narrow money growth might be an important determinant of cyclical developments in real GDP beyond effects already captured by short-term interest rates. In the empirical part we first present some preliminary evidence on the M1-GDP connection against the background of the situation in the US, based on an approach developed by Hamilton and Kim 2002. This test suggests that compared with the U.S., in the euro area, M1 has better and more robust forecasting properties than the term spread. These properties are also maintained when looking at a broader set of non-monetary indicator variables. Narrow money therefore seems crucial for cyclical developments. We also evaluate the relative out-of-sample forecasting performance of different classes of VAR models comprising real M1, GDP and further potential leading indicator variables against a univariate benchmark model. As a result, once the information from narrow money is taken into account, what matters more for the forecast performance, is the model class rather than the selection of additional indicators. While within the class of VARs in levels, Bayesian VARs are the best performing models, they are not capable of outperforming the benchmark. Specifically, only VARs in first differences are able to outperform the benchmark model.

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Paper provided by EconWPA in its series Macroeconomics with number 0303012.

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Length: 39 pages
Date of creation: 21 Mar 2003
Date of revision:
Handle: RePEc:wpa:wuwpma:0303012
Note: Type of Document - Acrobat PDF; prepared on IBM PC ; pages: 39 ; figures: included
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