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Understanding Euro area money demand

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Following the renewed interest for the role of money and credit in monetary policy, we assess the usefulness of long-run money demand equations for the European Central Bank. We perform a model evaluation exercise by means of the time varying cointegration test by Bierens and Martins (2010), comparing different models claiming to find a stable behaviour of Euro Area monetary aggregate M3. A time-invariant long-run relation is not rejected by data, when correctly specifying the set of explanatory variables. In particular, we find that the most relevant drivers of real money balances are a speculative motive represented by international financial markets, and a precautionary motive proxied by changes in the unemployment rate. We then estimate a stable cointegrated VAR including both motives, which allows us (i) to explain the anomalous behavior of M3 in the last decade and during the recent Great Financial Crisis, and (ii) to build a leading indicator of stock market busts. Our results have not negligible implications for policy decisions aimed at achieving financial stability.

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en

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http://eprints.lse.ac.uk/43341/

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