Does Money Matter for Inflation in the Euro Area?

By Kaufmann, Sylvia; Kugler, Peter | Contemporary Economic Policy, October 2008 | Go to article overview

Does Money Matter for Inflation in the Euro Area?


Kaufmann, Sylvia, Kugler, Peter, Contemporary Economic Policy


1. INTRODUCTION

The interest in monetary analysis in the euro area has considerably increased since some studies raised substantial doubts about the existence of a stable long-run money demand function, which seemed to be firmly established with data of the 1980s and 1990s (see, for instance, Bruggeman, Donati and Warne, 2003, Carstensen, 2006). This evidence against a prerequisite for monetary analysis within the frame of the quantity theory (Friedman, 1971) has been corroborated by results obtained when analyzing the relationship between money growth and inflation. Gerlach and Svensson (2003) and Nicoletti Altimari (2001) find that the predictive power of money growth for inflation is only minor, whereas real variables like the output gap and the real money gap have higher predictive power. On the other hand, in the spirit of Lucas (1980), some authors document the relevance of "trend" or core money growth for trend or core inflation, either by estimating the trend components with the Hodrick-Prescott (HP) filter (Neumann, 2003; Neumann and Greiber, 2004), with an exponentially weighted moving average filter (Gerlach, 2004), or with a low-frequency band filter (Assenmacher-Wesche and Gerlach, 2006, Bruggeman et al. 2005).

We provide additional evidence for the relevance of money growth for inflation in the euro area. We show that the link between money growth and inflation is also observable in the data without extracting the trend or core components of both time series. We do not design a structural model for inflation dynamics and do not rely on the assumption of a stable long-run money demand function as in, for example, Gerlach and Svensson (2003). Based on the statistical--the unit root and cointegration--properties of the data, we estimate a vector error correction model (VECM) for money growth and inflation, including additionally the output gap and a short-and a long-term interest rate. We find that the money stock M3 and the harmonized index of consumer prices are integrated of order 2, I(2), but cointegrated in their growth rates. Both interest rates are I(1) variables but cointegrated. This means that we work with a stationary term spread. Coenen and Vega (2001), Holtemoller (2004), and Dreger and Wolters (2006) also make a case for second-order integrated money stock and prices. The sample periods analyzed in Coenen and Vega and in Holtemoller end in 1998 and 2001, respectively. However, extending the sample beyond 2001 destroys the stable long-run money demand function estimated by these authors (Carstensen, 2006; Neumann and Greiber, 2004). Dreger and Wolters, on the other hand, estimate a stable money demand function by including the inflation rate as an additional measure for the opportunity cost of money holdings.

We proceed by using the cointegration property of money growth and inflation. This means that real money growth, which in order to have no accelerating or decelerating effect on inflation should on average equal real output growth and velocity changes, followed a stationary process between 1977 and 2006. The estimates show that deviations from this "balanced growth path" initiate substantial, significant dynamical adjustments in the inflation and in the money growth rate. Money growth innovations have a significant effect on inflation and account for up to 30% in the forecast error variance of inflation. Innovations in the output gap and both interest rates have only transitory effects on inflation and vanish in the medium term. Although inflation shocks also affect money growth in the long run, their importance is minor, as the largest share (up to 66%) in the forecast error variance of money growth is accounted for by own shocks.

The relationship between money growth and inflation remains stable even if we allow for generalized dynamics. The Markov switching VECM identifies a second regime, which prevailed at the end of the 1970s and beginning of the 1980s. …

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