Money Demand and the Role of Monetary Indicators in Forecasting Euro Area Inflation

29 Pages Posted: 14 Oct 2010

See all articles by Christian Dreger

Christian Dreger

European University Viadrina Frankfurt (Oder); IZA Institute of Labor Economics; Chinese Academy of Social Sciences (CASS)

Jürgen Wolters

Free University of Berlin (FUB)

Date Written: September 2010

Abstract

This paper examines the forecasting performance of a broad monetary aggregate (M3) in predicting euro area inflation. Excess liquidity is measured as the difference between the actual money stock and its fundamental value, the latter determined by a money demand function. The out-of sample forecasting performance is compared to widely used alternatives, such as the term structure of interest rates. The results indicate that the evolution of M3 is still in line with money demand even in the period of the financial and economic crisis. Monetary indicators are useful to predict inflation at the longer horizons, especially if the forecasting equations are based on measures of excess liquidity. Due to the stable link between money and inflation, central banks should implement exit strategies from the current policy path, as soon as the financial conditions are expected to return to normality.

Keywords: Money demand, excess liquidity, money and inflation

JEL Classification: C22, C52, E41

Suggested Citation

Dreger, Christian and Wolters, Jürgen, Money Demand and the Role of Monetary Indicators in Forecasting Euro Area Inflation (September 2010). DIW Berlin Discussion Paper No. 1064, Available at SSRN: https://ssrn.com/abstract=1691585 or http://dx.doi.org/10.2139/ssrn.1691585

Christian Dreger (Contact Author)

European University Viadrina Frankfurt (Oder) ( email )

Frankfurt (Oder)
Germany

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Chinese Academy of Social Sciences (CASS) ( email )

Beijing, 100732
China

Jürgen Wolters

Free University of Berlin (FUB) ( email )

Van't-Hoff-Str. 8
D-10785 Berlin, Berlin 14195
Germany
+49-30-838-2014 (Phone)
+49-30-838-4142 (Fax)

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