Re-Vitalizing Money Demand in the Euro Area: Still Valid at the Zero Lower Bound

Abstract

The analysis of monetary developments have always been a cornerstone of the ECB’s monetary analysis and, thus, of its overall monetary policy strategy. In this respect, money demand models provide a framework for explaining monetary developments and assessing price stability over the medium term. It is a well-documented fact in the literature that, when interest rates are at the zero lower bound, the analysis of money stocks become even more important for monetary policy. Therefore, this paper re-investigates the stability properties of M3 demand in the euro area in the light of the recent economic crisis. A cointegration analysis is performed over the sample period 1983 Q1 and 2015 Q1 and leads to a well-identified model comprising real money balances, income, the long term interest rate and the own rate of M3 holdings. The specification appears to be robust against the Lucas critique of a policy dependent parameter regime, in the sense that no signs of breaks can be found when interest rates reach the zero lower bound. Furthermore, deviations of M3 from its equilibrium level do not point to substantial inflation pressure at the end of the sample. Excess liquidity models turnout to outperform the autoregressive benchmark, as they deliver more accurate CPI inflation forecasts, especially at the longer horizons. The inclusion of unconventional monetary policy measures does not contradict these findings.

Keywords: Euro area money demand, inflation forecasts, unconventional monetary policy

JEL Classification: E41, E44, E52, G11, G15