On the Stability of Euro Area Money Demand and its Implications for Monetary Policy

We revisit the usefulness of long-run money demand equations for the European Central Bank. We first conduct a model evaluation exercise by means of a recent time–varying cointegration test. A stable relation for euro area M3 is not rejected by data only when accounting for both a speculative motive, represented by international financial markets, and a precautionary motive, proxied by changes in the unemployment rate. Second, relying on this finding, we propose and estimate a novel time-invariant specification for money demand which allows us (i) to build a leading indicator of stock market busts and (ii) to describe the anomalous behavior of M3 in the last decade. Excess liquidity matters for both financial and price stability. JEL Classification: E41, E52, C32