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A PORTOFOLIO BALANCE APPROACH TO
EURO-AREA MONEY DEMAND
IN A TIME-VARYING ENVIRONMENT

Stephen G.Hall
Leicester University and NIESR

George Hondroyiannis
Bank of Greece

P.A.V.B. Swamy
U.S. Bureau of Labor Statistics

George S. Tavlas
Bank of Greece

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 considers euroarea money demand in the context of the portfolio-balance framework. 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

JEL classification: C20; E41

Acknowledgements: The views expressed are those of the authors and should not be interpreted as those of their respective institutions.

Correspondence:

George Tavlas,
Economic Research Department,
Bank of Greece, 21 E. Venizelos Ave.,
102 50 Athens, Greece,
Tel. +30210-320 2370
Fax. +30210-320 2432
Email: gtavlas@bankofgreece.gr


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