Project funded under the Socio-economic Sciences and Humanities
European Commission
Money demand and excess liquidity
in the euro area
Christian Dreger, DIW Berlin
Jürgen Wolters, Freie University Berlin
Contribution of the paper
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Euro area money demand stable up to 2001, but
increasingly unstable afterwards
Long run relationship between money and
macroeconomy essential for monetary policy
Paper looks on stability using a standard money
demand framework
– Cointegration, vector in line with money demand
– No indication of significant money gap
– ECM consistent with battery of specification tests
– Role of inflation crucial for the results
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Studies with data up to 2001
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Long run relationship confirmed
– Fagan/ Henry (1998), Coenen/Vega (2001),
Funke (2001), Bruggemann/Donati/Warne (2003),
Brand/ Cassola (2004), Brüggemann/Lütkepohl
(2005)
Parameters stable, interest rate elasticity imprecisely
estimated. No role for asset markets
Results might arise due to aggregation
– Gorinello/Pastorello (2002), Holtemöller (2004),
Dreger/Schumacher (2004)
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Studies including data after 2001
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Failure to detect stable long run relationship
– Gerlach/Svensson (2003), Carstensen (2004),
Greiber/Lemke (2005)
Measures of uncertainty in financial markets enter long
run: Carstensen (2004), Greiber/ Lemke (2005)
– Financial uncertainty must be I(1)
Core components (HP filtered) and not original series:
Gerlach (2004), Neumann/Greiber (2004)
– Filter techniques not appropriate, end of sample
problems
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Specification of money demand
M / P  f (Y , OC )
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Standard empirical approach (Ericsson, 1998)
M nominal money, P price level, Y real income, OC
vector of opportunity costs of holding money
Opportunity costs: short and long term interest rates,
inflation rate (Coenen/Vega 2001)
Income has positive, opportunity costs negative
impact on real money balances
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Inclusion of inflation
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Opportunity costs of holding money instead of real
assets (Ericsson,1998)
Related to portfolio adjustment process in case of
inertia (Wolters/Lütkepohl, 1997)
Generalizes homogeneity restriction imposed between
money and prices
– Nominal money and prices I(2)
– System mapped into set of I(1) variables
(Holtemöller, 2004)
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Inclusion of asset prices
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Variations in equity markets can affect money demand
Sign ambiguous
– Positive scale effect: Higher asset prices raises
household wealth and money demand
– Negative substitution effect: Higher asset prices
make assets more attractive relative to money
Modifications of money demand function
– Money velocity (quantity theory)
– Stock market and housing prices
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Empirical design
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Introduction of the euro in 99.1, period too short to obtain
robust evidence
Artificial data in pre-euro period, constructed by
aggregation over euro area members
Several methods available (Artis/Beyer, 2004), might
influence the results
Differences are neglectable for money demand variables
after 1983 (Bosker, 2006)
EMS started working in 1983, sample period for this
study: 1983.1-2007.4
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Empirical design (cont‘d)
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Quarterly SA data, series in logs, except of interest
rates
M3 balances, 3m money, 10y bond market interest
rates (ECB)
GDP and GDP deflator (1995=100), Eurostat, q-o-q
annualized inflation rates
GDP data before 1991.1 from Brand/Cassola (2004):
Holtemöller (2004)
Impulse dummies: German unification (90.2), stock
market turbulences (01.1): Kontolemis (2002)
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Cointegration methods
X t    1X t 1  ...   k 1X t k 1  X t 1  ut
   '
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Johansen (1995) approach
VAR Process with p nonstationary variables, rewritten in
error correction form
Cointegration, if Π Matrix has reduced rank
Matrix an be separated into the feedback and
cointegration relationships
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Cointegration methods (cont‘d)
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Number of independent cointegration relations
determined by LR principles (trace test)
Improved critical values by MacKinnon, Haug and
Michelis (1999), small sample correction according to
Reimers (1992)
Long run parameters estimated using ML and S2S
methods
– ML produce distorted estimates in small samples,
S2S more robust
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Break in income elasticity
9.0
Real money balances
8.8
8.6
2002.1
8.4
8.2
8.0
7.8
6.9
7.0
7.1
7.2
7.3
7.4
7.5
7.6
Real income
Additional variable: product of income and a step dummy
equal to 1 from 2002.1 onwards
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Cointegration tests
Variables
Rank null
hypothesis
Johansen trace test
m-p, y, y*
0
1
2
21.33
4.83
0.21
m-p, y, π
0
1
2
47.97**
8.10
0.20
m-p, y, R
0
1
2
29.80
15.49
3.84
m-p, y, r
0
1
2
22.02
9.03
1.38
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Finite sample
correction
46.47**
Working Paper FINESS.D.X.X
Cointegration tests (cont‘d)
Variables
Rank null
hypothesis
Johansen trace test
m-p, y, y*, π
0
1
2
3
76.19**
18.44
4.37
0.08
m-p, y, y*, R
0
1
2
3
29.70
11.91
5.17
0.05
m-p, y, y*, r
0
1
2
3
35.58
15.15
5.77
0.83
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Finite sample
correction
73.02**
Working Paper FINESS.D.X.X
Cointegration vectors
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One cointegrating relation in (m-p, y, π) and (m-p, y,
y*, π)
– Parameter stability only if y* is included
Money demand with inflation as opportunity costs
– Similar results for Germany in pre-euro period
(Lütkepohl/Wolters, 2003)
Interest rates re-enter via term structure
– No impact on long run elasticities, slightly more
precise estimates
Financial Systems, Efficiency and Stimulation of Sustainable Growth
Working Paper FINESS.D.X.X
Deviations from long run
ecML  (m  p)  1.096 y  0.029 y*  5.534   4.855( R  r )
(0.080)
(0.004)
(0.566)
(0.959)
ecS 2 S  (m  p)  1.297 y  0.023 y*  3.348   3.233( R  r )
(0.064)
(0.003)
(0.450)
(0.761)
.25
.20
.15
.10
.05
.00
-.05
-.10
-.15
-.20
84
86
88
90
92
94
ML
Financial Systems, Efficiency and Stimulation of Sustainable Growth
96
98
00
02
04
06
S2S
Working Paper FINESS.D.X.X
Deviations from the long run (cont‘d)
ec(shr )  (m  p  y)  0.031 shr  6.475   5.967( R  r )
(0.004)
(0.652)
(1.251)
ec( phr )  (m  p  y )  0.057 phr  6.512   6.047( R  r )
(0.007)
(0.656)
(1.258)
.3
.2
.1
.0
-.1
-.2
-.3
84
86
88
90
92
94
EC(SHR)
Financial Systems, Efficiency and Stimulation of Sustainable Growth
96
98
00
02
04
06
EC(PHR)
Working Paper FINESS.D.X.X
Real money gap
rmgt  ect  1 ( yt  yt )   2 ( Rt  Rt )   3 (rt  rt )   4 ( t   t )
.04
.00
-.04
-.08
-.12
-.16
84
86
88
90
92
94
ML
Financial Systems, Efficiency and Stimulation of Sustainable Growth
96
98
00
02
04
06
S2S
Working Paper FINESS.D.X.X
Single equation ECM
Money demand specifiction
(m  p)t   0.048 0.055 ecS 2 S ,t 1  0.034 d 902  0.030 d 011  0.185  t
(5.41)
(6.28)
(8.13)
(6.99)
(5.90)
 0.165 (m  p)t 1  0.146 (m  p )t 3  0.201 (m  p )t  4  0.234 rt
(2.48)
(2.28)
(3.05)
(3.15)
Velocity and wealth effects
(m  p  y )t  0.043 0.034 ec phr ,t 1  0.847 phrt  1.262 phrt 1  0.599 phrt 2
(3.66)
(3.60)
(4.81)
(3.91)
(2.17)
 0.235  t 1  0.358 Rt  0.419 rt 1  0.440 rt 2  0.025 d 902
(2.61)
(1.95)
Financial Systems, Efficiency and Stimulation of Sustainable Growth
(2.29)
(2.36)
(3.58)
Working Paper FINESS.D.X.X
Conclusions
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Findings in contrast to most recent papers
– Robust link between money and real side of the
economy, interpreted in terms of money demand
– Permanent break in income elasticity, linked to
movements in asset prices
– Real money gap indicates no inflation pressures
from monetary side
Results achieved by proper interpretation of the role of
inflation in the cointegration vector
– ECM robust to a wide range of specification tests
Support for monetary target in ECB strategy
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Working Paper FINESS.D.X.X