DOES THE P * MODEL PROVIDE ANY RATIONALE FORMONETARY TARGETING ? by Lars E . O . Svensson INSTITUTE FOR INTERNATIONAL ECONOMIC STUDIES Stockholm University

The so-called P ¤ model is frequently used or referred to in discussions of monetary targeting. This gives the impression that the P ¤ model might provide some rationale for monetary targeting or for the monetary reference value used by the Eurosystem. The P ¤ model implies that in‡ation is determined by the level of and changes in the “real money gap” (the deviation of current real balances from their long-run equilibrium level), and hence that the real money gap is an important indicator for future in‡ation. Nevertheless, the P ¤ model does not seem to provide any rationale for either a Bundesbank-style money-growth target or a Eurosystem-style money-growth indicator. Keywords: Real balances, reference value, in‡ation targeting JEL Classi…cation Numbers: E42, E52, E58 ¤I thank Paul De Grauwe, Stefan Gerlach, Berthold Herrendorf, Manfred Neumann, Karl-Heinz Tödter and Volker Wieland for comments on a previous version, Thomas Eisensee for research assistance and Christina Lönnblad for secreterial and editorial assistance. Interpretations and any errors are my own. Email: Lars.Svensson @iies.su.se. Homepage: http://www.iies.su.se/leosven/. 1. Introduction The so-called P ¤ model (see Hallman, Porter and Small [14]) is often used (or at least referred to) in discussions of monetary targeting (for instance, in Jahnke and Reimers [17], Neumann [21], Tödter and Reimers [27], Tödter and Ziebarth [28] and von Hagen [29]). This may give the impression that the P ¤ model provides some rationale for money-growth targeting, especially since the P ¤ model seems to be part of the Bundesbank’s view of the transmission mechanism of monetary policy, see Jahnke and Reimers [17]. This short paper examines whether the P ¤ model indeed provides any such rationale. Furthermore, in its monetary strategy, the Eurosystem has given a prominent role to a money-growth indicator, the deviation of current M3 growth from a speci…ed reference value, as an indicator of “threats to price stability” (see ECB [9]-[11]). Using conventional aggregatesupply and aggregate-demand relations, Svensson [26] has argued that this money-growth indicator is likely to be an inferior indicator of such threats, and that an in‡ation forecast is instead the natural indicator. This paper also examines whether the P ¤ model provides any support for the Eurosystem money-growth indicator. The main result of the paper is that, although the P ¤ model gives a prominent role to real balances in forecasting in‡ation and, hence, to a “real money gap” as an important indicator, it does not provide any support for either a Bundesbank-style money-growth target or a Eurosystem-style money-growth indicator. Section 2 presents a slight generalization of the basic P ¤ model. Section 3 relates in‡ation and real balances. Section 4 derives in‡ation forecasts for the P ¤ model. Section 5 speci…es a money-demand function. Section 6 compares in‡ation targeting and money-growth targeting. Section 7 discusses the reaction functions that follow from the two kinds of targeting. Section 8 presents the conclusions. 2. The P ¤ model De…ne (log) velocity vt by the quantity equation, vt ́ pt + yt ¡mt; (2.1) where pt, yt and mt are the (logs of the) price level, output and (nominal) money, respectively, in period t.