Issues in money demand: the case of Europe

Abstract:

This article establishes a co-integration analysis for the euro area (sample period: 1983-2000), identifying three co-integrating vectors: one which can be labelled money demand (in which real M3 money balances are related to output, with unit elasticity, and the long rate of interest); another pertaining to the spread between the short and long rate of interest; and a third which is an output (IS) relationship in which output is related to the real rate of interest. Currency substitution terms affect the adjustment of real money balances though they do not enter the co-integration space. We use the aggregation procedure for historical Euroland data advocated by Beyer, Doornik and Hendry for application to aggregation of money, GDP and prices when exchange rates were varying. We make use of the German short- and long-term interest rates as benchmarks for own rate and opportunity cost variables.