Money and Inflation in the Euro Area During the Financial Crisis

Abstract

This paper explores the stability of the relation between money demand for M3 and inflation in the euro area by including the recent period of the financial crisis.Evidence is based on a cointegration analysis, where inflation and asset prices are allowed to enter the long run relationship. By restricting the cointegrating space, equations for money and inflation are identified. The results indicate that the equilibrium evolution of M3 is still in line with money demand. In the long run, inflation is affected by asset prices and detrended output. Excess liquidity plays an important role for inflation dynamics. While the hypothesis of weak exogeneity is rejected for real money balances and inflation, real income, real asset prices and the term structure do not respond to deviations from the long run equilibria. A single equation analysis derived from this system still provides reliable information for the conduct of monetary policy in real time, since the error correction terms are very similar to those obtained by the system approach. To monitor the monetary development, a single money demand equation is sufficient, at least as a rough indication.

On the Stability of Euro Area Money Demand and Its Implications for Monetary Policy

“…In particular, Carstensen () proposes to add equity returns and stock market volatility to account for the stock market impact on real balances, while Beyer () stresses the role of housing wealth in capturing the trending behaviour of money in the first ten years of ECB existence. Dreger and Wolters (, consider also real house prices as a measure of real financial wealth and then further develop their argument by analyzing the relation between money and inflation in the Global Financial Crisis.…”

“…Woodford, ; McCallum and Nelson, ; De Santis et al ., ), a growing interest is devoted to understanding the effects of liquidity injections by the ECB and other central banks in terms of future inflation (see e.g. Dreger and Wolters, ) and the link between money and inflation during and after financial crises (Reynard, ). To address these issues, in our second policy exercise, we evaluate the relevance of our monetary overhang measure in explaining inflation.…”

A Survey of Studies on Money Demand and Inflation Amidst Banking Crisis

“…Besides, the results are mixed with respect to inflation when compared to money demand. Dreger and Wolters (2011) introduced an interesting direction as the study provided empirical evidence on the stability of the relation between money demand and inflation in the Euro Area by including the recent financial crisis. VAR model and cointegration analysis in which inflation and asset price (nominal house prices) were allowed to enter the long-run relationship were used.…”