Estimating a European Demand for Money

The creation of European Monetary Union (EMU) poses a number of difficult problems for the European Central Bank (ECB). One of the major problems is related to the uncertainty about economic relationships within the euro area. The monetary strategy of the ECB is based on two pillars, one is the use of a monetary reference value and the other a combination of various other indicators. A precondition for being able to use money as a prominent indicator is the existence of a stable money demand. This paper presents estimates of such a European money demand for narrow and broad money for the actual EMU countries (excluding Luxembourg), employing quarterly aggregate data from 1964 to 1994. Applying a general-to-specific modelling technique, it is argued that statistically satisfactory and economically interpretable money demand functions can be found. As indicated above, the existence of stability is of great importance for policy. Reflecting this concern, out-of-sample (20 quarters) forecasting tests are performed which indicate that the estimated equations are stable. Though one can interpret the start of EMU as a structural break invalidating the use of historical data, a couple of counter arguments against this view are being discussed. Instead, the paper argues that it is unlikely that a sharp break will occur. This raises the hopes that the ECB will face a stable money demand and be able - at least for a certain time - to use past aggregate data for policy purposes