1. 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

2. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Contribution of the paper 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

3. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Studies with data up to 2001 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)

4. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Studies including data after 2001 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

5. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Specification of money demand 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

6. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Inclusion of inflation 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)

7. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Inclusion of asset prices 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

8. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Empirical design 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

9. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Empirical design (cont‘d) 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)

10. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Cointegration methods 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

11. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Cointegration methods (cont‘d) 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

12. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Break in income elasticity Additional variable: product of income and a step dummy equal to 1 from 2002.1 onwards

13. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Cointegration tests VariablesRank null hypothesis Johansen trace testFinite sample correction m-p, y, y*012012 21.33 4.83 0.21 m-p, y, π012012 47.97** 8.10 0.20 46.47** m-p, y, R012012 29.80 15.49 3.84 m-p, y, r012012 22.02 9.03 1.38

14. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Cointegration tests (cont‘d) VariablesRank null hypothesis Johansen trace testFinite sample correction m-p, y, y*, π01230123 76.19** 18.44 4.37 0.08 73.02** m-p, y, y*, R01230123 29.70 11.91 5.17 0.05 m-p, y, y*, r01230123 35.58 15.15 5.77 0.83

15. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Cointegration vectors 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

16. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Deviations from long run

17. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Deviations from the long run (cont‘d)

18. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Real money gap

19. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Single equation ECM Money demand specifiction Velocity and wealth effects

20. Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X Conclusions 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