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

Stephen Hall, George Hondroyiannis, P.A.V.B. Swamy and George Tavlas

No 08/9, Discussion Papers in Economics from Division of Economics, School of Business, University of Leicester

Abstract: 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.

Keywords: Money demand; VEC, time varying coefficient estimation; Euro area (search for similar items in EconPapers)
JEL-codes: C20 E41 (search for similar items in EconPapers)
Date: 2008-04
New Economics Papers: this item is included in nep-cba, nep-eec, nep-mac and nep-mon
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Citations: View citations in EconPapers (15)

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Working Paper: A Portofolio Balance Approach to Euro-Area Money Demand in a Time-Varying Environment (2007)
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