Correlation between the growth of monetary aggregates and inflation : implications for the conduct of monetary policy in the euro area

Correlation between the growth of monetary aggregates and

inflation

Implications for the conduct of monetary policy in the euro area

Author’s name: Daniel Ishikawa Student number: 0337749

Semester 2, block 4

Date of completion of the paper: 3 July 2006

Course involved: Monetary Economics

Name of the instructor: Dr. Massimo Giuliodori

Department: Faculty of Economics and Business

Universiteit van Amsterdam

1. Introduction

Monetary policy, commonly defined as the process of managing the money supply in pursuit of price stabilization, is conducted differently among central banks. The monetary policy of the European Central Bank (ECB) is based on what is known as a two-pillar strategy, which relies on two main elements, i.e. the economic and monetary analysis. The second pillar, economic analysis, considers many variables which are thought to have a clear and reliable impact on inflation, the ultimate target of the ECB. Variables include the developments in overall output, the demand and labor market conditions, and a broad range of price and cost indicators. In addition to that and unlike other central banks such as the Federal Reserve of the United States, the ECB pursues a monetary analysis in that it maintains a reference value of 4.5 percent for the annual growth of M3, a measure frequently used to proxy monetary aggregates.

This strategic decision has stirred heated controversy among economists and continues to be scrutinized primarily due to the alleged low correlation between money and inflation. To date, relatively few studies have successfully combined the insights from different sources related to the ECB’s monetary analysis, although the controversy over its importance has produced an abundant amount of research papers. Instead, most studies focus on particular aspects of the discussion.

This thesis is an attempt to fill this gap. For this purpose, this paper critically evaluates the ECB’s monetary policy framework by discussing a diversified pool of positions that have emerged in recent years in response to the ECB’s controversial strategy decision. In particular, this paper evaluates the role of money as an inflation indicator by empirically testing for the long-run correlation between money growth and inflation in part in a comparative perspective. Therefore, the empirical analysis does not only cover the euro area but also includes the experience of both the United States and Japan. Moreover, it is shortly analyzed whether recent surges in asset prices can be made responsible for the decline in correlation between money and inflation; these findings are analyzed for monetary policy implications in the euro area. This thesis thereby offers more balanced argumentation that provides a global overview of the current academic discussion on this particular topic.

The remainder of the paper is thus organized as follows. Section 2 offers an overview of the dominant notions in the field. Section 3 puts the correlation between money growth and inflation into perspective and explains its relevance for the conduct of monetary policy in the euro area. Section 4 provides an empirical analysis of the correlation between money growth and inflation for the euro area, the United States and Japan. Section 5 aims at explaining the recent decline in

the correlation between money growth and inflation and elaborates on implications for the conduct of monetary policy in the euro area. Section 5 presents the conclusion to this paper.

2. Literature review

Since the European Central Bank (ECB) first published its guidelines for its monetary policy, its two-pillar strategy has been under intense academic scrutiny, especially due to the presence of monetary analysis. The continuing academic interest can be inferred from the vast amount of recent literature dedicated in particular to the ECB’s monetary pillar. The aim of this section is not to provide an exhaustive list of previously published studies and their various views, as reviewing the existing literature in great detail would go beyond the scope of this work. Rather, it is the intention to present the most recent discussions found in the literature and relate it to the subsequent empirical analysis.

In fact, a wide spectrum of academic literature has emerged that specifically analyzes the relevance of monetary analysis for the conduct of monetary policy. At one end of the spectrum, there are economists who argue that reliance on monetary aggregates as an indicator can lead to perverse monetary policy decisions due to the allegedly poor correlation between monetary aggregates and inflation. At the other end, however, there is a smaller group of economists that is being supportive of the ECB’s strategy decision to include monetary analysis in their decision-making process mainly because according to their findings monetary aggregates provide meaningful insights into the long-term development in the money market.

Among others, DeGrauwe and Polan (2001) argue that monetary aggregates are poor indicators of risks to price stability. In fact, DeGrauwe and Polan (2001) even go a step further and question the long-run correlation between money and inflation. Running a regression on two separate samples, DeGrauwe and Polan investigate the relationship between inflation, the dependent variable, and money and income, the two independent variables. One regression analysis, performed on the larger sample that includes 116 countries, reveals that the coefficient of the money variable is statistically significant and has the expected sign in that it is positive. The long-run correlation seemingly holds for this particular set of countries. More interestingly, however, the correlation breaks down once the regression analysis is limited to a subsample restricted to countries that have operated in moderate inflation environments. Since most euro area countries can be shown to belong to this category of

countries, their study refutes the applicability of the ECB’s two-pillar strategy and its reliance on the monetary analysis.

Begg, D., Canova, F., DeGrauwe, P., Fatás, A., and Lane, P.R. (2002) represents another study that has addressed the relationship between money and inflation; this time, however, from a shot-run perspective. It investigates recent euro area data and finds that the correlation between money and inflation has the wrong sign in that it is negative. Moreover, this paper shows that the euro area’s money growth has repeatedly exceeded the reference value of 4.5 percent in spite of the ECB’s pledged commitment to maintain a money growth below that level. This development is argued to be indicative of money’s inability to provide reliable insights.

Naturally, there are also economists who are supportive of the ECB’s strategic decision to include monetary analysis into their decision-making process. A number of arguments are presented in ECB’s working papers, many of which rely on complex models incorporating sophisticated econometric techniques. Most importantly, they point to the important medium- and long-run correlation between money and inflation. Perhaps the most appealing of the more recent papers, Altimari (2001), in essence bases its findings on a theoretical model that is derived from the simple and well-known quantity theory. More specifically, the econometric analysis makes use of a theoretical notion known as the P-Star approach. According to this approach, p* is defined as the price level that is consistent with the current money supply and a contemporary equilibrium in both the financial and the goods markets. As, in expectation, the difference between the actual price level, here p, and the equilibrium price level, p*, revert to zero, it is argued that temporary deviations from the equilibrium can be indicative of upcoming inflationary pressures. Moreover, the P-Star approach assumes that deviations of velocity from trend levels can also serve as a warning indicator. On the basis of these two simplifying assumptions, Altimari (2001) comes to the important and often cited

conclusion that money (within this theoretical framework) seems to perform reasonably well

at predicting inflation at medium-term horizons, which, in turn, is supportive of the ECB’s current monetary policy strategy.

In conclusion, the jury is still up on whether the ECB’s monetary pillar is reliable and useful for monetary policy purposes. Most of the discussion revolves around the question whether there is a reliable long-run correlation between money growth and inflation.

3. The correlation between money growth and inflation in perspective

In the 1970s the majority of central banks used to engage in a monetary targeting regime by assigning an overriding role to monetary aggregates in their conduct of monetary policy. Yet, over time, the importance of monetary aggregates has diminished (King, 2002). Consequently, most central banks have shifted away from a system known as monetary targeting to inflation targeting. In fact, the existence of a stable relationship between money growth and inflation is commonly considered a prerequisite for the use of monetary aggregates in the conduct of monetary policy. The following three stylized facts might help explain why monetary policy has recently lost in significance.

First, money demand is frequently argued to have become inherently unstable especially in the 1970s and again in the beginning of the 1990s. Several studies, inter alia Whitesell (1997) and Dotsey et al. (2000), have found on the basis of US data that there has been a structural breakdown in that M2 growth slowed down in the 1990s in spite of a considerable reduction in its opportunity cost. This and related findings are used in order to argue that the outcome of monetary policy decisions has become difficult to predict. Indeed, much of the breakdown is argued to be attributable to financial innovation and to an increase in the household investments in bond and stock mutual funds (Mehra, 1997). Due to financial innovation, numerous near-money substitutes have come to existence, many of which bear interest rates. In response to that, there has apparently been a downward shift in the demand for money relative to GDP and an increase in velocity. However, a rise in money’s own rate of interest relative to other assets may as well lead to a decline in velocity, if the increasingly close money substitutes bear interest (Bain and Howells, 2003). Hence, the overall direction of velocity as well as its rate has increasingly become unpredictable.

Second, it has become increasingly clear that monetary aggregates are difficult to control (Bain and Howells, 2003). However, one important prerequisite for a successful monetary base control is that the central bank has control over the size of the monetary base and that changes thereof lead to a predictable change in the broad money stock, as is predicted by the base-multiplier approach to money supply determination. The reasons for the apparent loss in controllability are many. For instance, it is difficult to predict the exact market flows that lead to change in the money base, since the forecasts that the very intervention is based on is subject to constant changes. In practice, frequent interventions were required to undo unintended changes in the money base. Moreover, policy actions aimed at offsetting a

predicted expansion of money would require a sale of bonds or other government debt to the non-bank private sector. This, however, would severely impact debt markets and thereby lead to unwarranted volatility of market interest rates. Again, continuous actions would be required to remedy this problem.

Third, and perhaps most interestingly, numerous studies suggest that the often found strong correlation between money growth and inflation is largely due to the presence of high-inflation countries in the sample set (DeGrauwe and Polan, 2005). If these countries are excluded from the sample, the correlation between these variables is said to be considerably weaker. Other studies find that the correlation has declined especially in the 1990s.

The third stylized fact has moved into the center of attention in recent years, especially because the first two points have been found to be more of a country-specific phenomenon that might not be of as much relevance in the pan-European framework (Calza and Sousa, 2003). Apparently, broad money demand has proven to be more stable in the euro area than in other economies of comparable size due to two main reasons. First, studies find that the observed instability was resulting from variant country-specific problems. Next to that, financial innovation seemingly had a lower impact upon money demand in the euro area than in other economies. Most importantly, there appears to be a growing consensus among many academics in the field that at least in the euro area framework aggregate euro area data are expected to average out de-synchronised shocks to money demand of individual member countries, in which case money demand can be expected to be more stable in the euro area than in other comparable economies (Calza and Sousa, 2003).

This study therefore disregards the first two stylized facts presented above and instead focuses on the third controversial finding concerning the long-run correlation between money and inflation. Indeed, the ECB has frequently used a theoretical construct known as the quantity theory of money in order to point to the long-run correlation between those two variables and justify its controversial decision to assign a prominent role to monetary aggregates in its conduct of monetary policy. In fact, the quantity theory is most often used in Fisher’s version. In this form, this notion stipulates that changes in money supply are reflected by proportionate changes in inflation. Thus, the quantity theory of money (QTM) explains changes in inflation by monetary forces. In brief, changes in nominal variables such as money are assumed no to impact real variables such as income. However, there are a number of limitations of the quantity theory. The most obvious flaw is that it assumes away adjustment problems. Clearly, an unexpected money supply increase does not immediately translate into inflation. Rather, prices are sticky so that the increase in money supply (nominal variable) can

have a temporary impact on variables such as real output (real variable).

The mechanisms behind this theory can be explained using a line of events known as the monetary transmission mechanism. Suppose money supply increases unexpectedly and inflation expectations do not adjust instantaneously due to rigidities in the formation of expectations. As a result of that, interest rates will decrease, as households demand higher real money balances. Due to the expectational rigidities, the decrease in nominal interest rates goes hand in hand with a decline in real interest rates. Consequently, both the expenditures on consumption and investments increase since both variables negatively depend on interest rates. Therefore, in the short run, firms will respond by increasing output. In the long run, however, calls for higher wages will inevitably lead to an upward adjustment in the general price level.

This outcome is precisely what the QTM predicts. The initial increase in money supply has no long-run impacts on real variables such as income. Bearing this in mind, we start with the well-known identity of the form:

M*V = P*T

where M represents the stock of money, PT is the value of transactions undertaken and VT is the velocity of money. If we rewrite this equation and transform it into the logarithmic form, the general price level can be shown to be a function of money growth and income:

Δ p = Δ m – Δ y + Δ v

The following assumptions are crucial in transforming this identity into a theory. First, it is assumed that an exogenous increase in the quantity of money leads to an equal change in the general price level. In other words, the coefficient of money equals unity. Second, the assumption of the long-run neutrality of money stipulates that changes in the quantity of money have no lasting impact on income and velocity. Simply put, money is neutral over prolonged time horizons. The intuition behind this notion has been laid out above.

Under the simplifying assumption that the change in velocity is zero and that output growth has a tendency to mean revert around a trend growth, money supply growth can be expected to show a close relationship with inflation that takes the from:

In part on the basis of this theoretical framework, and in apparent contrast to other central banks’ practices, the ECB has to date adhered to a monetary policy strategy incorporating characteristics that are normally attributed to a monetary targeting regime. In fact, the ECB makes three crucial assumptions about the variables involved in the quantity theory to arrive at the aforementioned 4.5 percent annual monetary growth target: an annual inflation rate of 2 percent, a real GDP growth of 2 percent, and a trend decline in the rate of velocity of 0.5 percent (ECB, 1998).

In October 1998, the Governing Council, the decision-making body of the ECB, announced its monetary policy strategy for the euro area, opting for an unorthodox mix of elements derived from both the monetary and the inflation targeting traditions. Initial publications of the Governing Council clearly indicate that monetary analysis plays a prominent role in the ECB’s implementation of its monetary policy (ECB, 1998). Only in 2000 Issing (2000) emphasized that the “one-to-one relationship between money and prices in the long run (is) one of the few results that have remained undisputed over time and across countries.”

In subsequent publications, the ECB appears more cautious when it refers to the degree of importance attributed to monetary analysis, most likely because the growth of monetary aggregates has repeatedly exceeded the level prescribed by the reference value. For instance, it is clarified that the monetary pillar’s primary purpose is to ensure that the ECB does not lose sight of the long-run development in the money market (Issing, 2000). The ECB is thus believed by many to have somewhat departed from the strict adherence to monetary analysis (Jaeger, 2003). Yet, it continues to maintain a reference value for the annual growth of monetary aggregates of 4.5 percent, which remains subject to annual review.

4. Empirical evidence on the correlation between money growth and inflation

Thus far, it has been established that the quantity theory of money relates money growth to inflation and that the ECB is often criticized for following the unorthodox practice of assigning a prominent role to monetary aggregates in its conduct of monetary policy. Clearly, this eclectic approach is justified only if money indeed contains information relevant to ECB’s policy of combating risks to price stability. In other words, it has yet to be shown what the time horizon is that is most closely associated with inflation. This question will be

addressed using the quantity theory alluded to above. The reader is reminded that this discussion does not aim at presenting monetary targeting as a substitute for inflation targeting. Rather, it evaluates whether the ECB policy of complement inflation targeting with a medium- to long-term monetary focus appears to be empirically justifiable.

For this purpose, the relationship between money and inflation relies on moving averages and is examined across four different time periods: 1, 2, 4, and 6 years. For instance, the 2 year moving average for the year 2005 represents an average of the annual money growth and inflation data from the years 2004 and 2005 etc. Although the main interest lies in the euro area data, all these relationships will also be analyzed for data from Japan and the United States to have comparable statistics.

As for the euro area data, this study relies on aggregated quarterly data for the period 1971Q1 to 2005Q4 provided by the ECB and Datastream. Money growth is measured as the annual change in the stock of not seasonally adjusted M3. Income is proxied by the annual change in GDP. Inflation is measured as the annual change in the Harmonized Index of Consumer Prices (HICP). The US data has been retrieved from the Federal Reserve. As far as the Japanese data are concerned, the study uses data provided by the Bank of Japan.

Figure 1 Money growth and inflation in the euro area for various time horizons

(a) Annual growth rates (b) 2-year averaging period

0 2 4 6 8 10 12 14 16 18 1971q01 1972q04 1974q03 1976q02 1978q01 1979q04 1981q03 1983q02 1985q01 1986q04 1988q03 1990q02 1992q01 1993q04 1995q03 1997q02 1999q01 2000q04 2002q03 2004q02 2006q01 CPI M3 0 2 4 6 8 10 12 14 16 18 1970 1972 1974 1976 1978 1980 19821984198619881990199219941996 1998 2000 2002 2004 CPI M3

(c) 4-year averaging period (d) 6-year averaging period

0 2 4 6 8 10 12 14 16 1970 19721974 1976 197819801982 1984 198 6 198 8 1990 1992 199419961998 200 0 200 2 2004 CPI M3 0 2 4 6 8 10 12 14 16 197619781980 1982 1984198619881990 19921994 19961998 20002002 2004 CPI M3

Table 1 Correlation coefficient of money growth and inflation for two time spans (euro area) Averaging period 1976-1990 1991-2005 1 year 51,26% 20,00% 2 years 62,21% 40,46% 4 years 76,07% 53,23% 6 years 74,07% 62,11%

Source: ECB, BarclaysCapital; own calculations.

Figure 1 shows that money growth does appear to follow a co-movement with inflation in the period from 1971 to 2005. In other words, consumer price inflation appears to move with the growth in money supply, if one makes allowance for some temporary deviations. Even though this relationship exists already for the 1-year averages, it is most pronounced for the 6-year horizon. The correlation coefficient for two separate time spans is shown in table 1; during the period from 1976 to 1990, the 1 year correlation coefficient stands at around 50 percent, while the 6 year averaging period during the same time span exhibits a correlation of almost 75 percent. Interestingly, the correlation appears to have substantially weakened especially since the 1990s; indeed, the 6 year correlation coefficient drops from a level of approximately 75 percent in the first time span to close to 60 percent in the second one. This observation is in line with that of other authors that have used more elaborate econometric techniques and come to the conclusion that there has been a decline in correlation between these two variables in recent years.

Figure 2 Money growth and inflation in the United States for various time horizons

(a) Annual growth rates (b) 2-year averaging period

0 5 10 15 20 25 30 1971q01 1972q04 1974q03 1976q02 1978q01 1979q04 1981q03 1983q02 1985q01 1986q04 1988q03 1990q02 1992q01 1993q04 1995q03 1997q02 1999q01 2000q04 2002q03 2004q02 CPI M3 0 2 4 6 8 10 12 14 19701972197419761978 198019821984198619881990199219941996 1998200020022004 CPI M3

(c) 4-year averaging period (d) 6-year averaging period 0 2 4 6 8 10 12 1970 1972 1974 1976 19781980 1982 1984 1986 1988 1990 1992 1994 19961998 2000 2002 2004 CPI M3 0 2 4 6 8 10 12 1970 19721974 1976 1978 1980 1982 1984 1986 1988 1990 1992 19941996 1998 20002002 2004 CPI M3

Source: Federal Reserve System, BarclaysCapital; own calculations.

Table 2 Correlation coefficient of money growth and inflation for two time spans (USA)

Averaging period 1976-1990 1991-2005

1 year 11,31% -42,30%

2 years 24,35% -47,06%

4 years 46,28% -53,14%

6 years 65,31% -62,33%

Source: Federal Reserve System, BarclaysCapital; own calculations.

In the United States, the relationship between money growth and inflation is also clearly positive until the 1990s. As was the case with the euro area data, the relationship intensifies with the increase in the averaging period. Since the beginning of the 1990s, however, there has been a break in the co-movement. A glance at the figures from table 2 reveals that it has even been negative during the second time span. In general, it is evident that the relationship is not as pronounced as in the case of the euro area.

Figure 3 Money growth and inflation in Japan for various time horizons

(a) Annual growth rates (b) 2-year averaging period

-5 0 5 10 15 20 25 30 35 1971q01 1972q04 1974q03 1976q02 1978q01 1979q04 1981q03 1983q02 1985q01 1986q04 1988q03 1990q02 1992q01 1993q04 1995q03 1997q02 1999q01 2000q04 2002q03 2004q02 2006q01 CPI M3 -5 0 5 10 15 20 25 30 1970 1972 1974 1976 19781980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 CPI M3

(c) 4-year averaging period (d) 6-year averaging period -5 0 5 10 15 20 25 1970 1972 197419761978 1980 198219841986 1988 1990 19921994 1996 1998 2000 200 2 2004 CPI M3 -5 0 5 10 15 20 1970 1972 1974 1976 1978 19801982 1984 19861988 1990 1992 19941996 1998 20002002 2004 CPI M3

Source: Bank of Japan (BoJ), BarclaysCapital; own calculations.

Table 3 Correlation coefficient of money growth and inflation for two time spans (Japan)

Averaging period 1976-1990 1991-2005

1 year 34,82% -20,32%

2 years 61,40% 15,74%

4 years 81,03% 53,49%

6 years 87,01% 60,56%

Source: Bank of Japan (BoJ), BarclaysCapital; own calculations.

The results for Japan are similar to that obtained for the euro area in that there is a strong correlation between money and inflation in the first time span in question. Indeed, money growth and inflation appear to closely move together as is confirmed by the figures from table 3. That is, an increase (decline) in money growth is accompanied by a similar rise (fall) in the inflation rate. For instance, there has been a correlation that is in the proximity of 90 percent for the 6 year averaging period during the period between 1976 and 1990. Overall, the results are similar to that observed for the other two countries.

5. Explaining the recent decline in the correlation between money and prices

The preceding empirical analysis has pointed to a recent decline in the correlation between money and inflation in all three countries in question. This observation has also been made by other authors including DeGrauwe and Polan (2005) and is frequently cited by voices that are critical of the ECB monetary policy. Therefore, the below discussion provides possible explanations for the recent decline and shows that it does not necessarily refute the importance of money as a warning indicator for inflation.

In fact, the link between excess money supply and asset prices has fairly recently been identified as one possible reason for the recent decline in the correlation between money and inflation. Therefore, the next necessary step is to test for the relationship between annual “nominal wealth” growth and money for the period 1980 to 2005. This relationship is tested only for the euro area. Following the approach by Polleit (2005), nominal wealth is defined here as the sum of Gross Domestic Product and total stock market capitalization. Clearly, this definition requires justification. In fact, GDP alone does not directly account for stock market developments. Therefore stock market capitalization is added to the GDP as a proxy for asset prices in order to account for developments in the overall stock of assets. Indeed, it is frequently argued that especially in the 1990s “excess” demand pressures have showed up first in credit aggregates and asset prices (captured here by the stock market capitalization), rather than in the prices of goods.

Figure 4 Money growth and “nominal wealth” in the euro area

-40 -30 -20 -10 0 10 20 30 40 50 Q1 80 Q1 83 Q1 86 Q1 89 Q1 92 Q1 95 Q1 98 Q1 01 Q1 04 -1 1 3 5 7 9 11 13 15 GDP plus stocks M1

Source: ECB, BarclaysCapital, Datastream; own calculations – The correlation coefficient

with a 2 year lag between money growth and “nominal wealth” growth is 0.42 from 1982Q1 to 1993Q4 and, from 1994Q1 to 2004Q4 0.76 .

The correlation between annual “nominal wealth” growth and money growth is weak in the 1970s and 1980s. As can be inferred from figure 4, the relationship becomes increasingly pronounced in the 1990s. In other words, nominal wealth growth increasingly follows money growth. Indeed, the simple correlation coefficient of money growth and “nominal wealth” increases from 40 percent (from 1982 to 1993) to 75 percent (from 1994 to 2005). More interestingly even, consumer prices (as measured by the CPI) have declined in the same period in spite of a contemporaneous increase in nominal wealth (not shown here).

The weakening relationship between money growth and consumer price inflation can possibly be explained by the fact that in the recent past money growth might have

increasingly translated into asset prices such as stocks, bonds real estate and real estate, rather than final product prices.

These asset prices are not fully captured by consumer price indices such as the Harmonized Consumer Price Index used by the ECB. Therefore, the potential existence of "asset price bubbles" might have contributed to the weakening relationship between money growth and “traditional” inflation measures. Clearly, asset price increases that do not immediately translate into consumer price inflation represent a “hidden” inflation. As such, uncontrolled increases in money supply can indeed represent a risk to price stability. Moreover, signals derived from money supply developments might be more important for inflation than current central bank practice suggests. In conclusion, the above findings may point to the fact that inflation targeting should be complemented by monetary targeting so that asset price developments are also accounted for.

It is interesting to observe that much of the criticism brought against the ECB’s monetary policy strategy revolves around the recent development in the growth of monetary aggregates. In fact, the ECB has been frequently criticized for missing its own monetary growth target of 4.5 percent. As figure 1 clearly demonstrates, the growth of M3, a measure used to proxy money, has at times exceeded that value. This has become particularly evident in the aftermath of the September 11 attacks. Some critics, e.g. Begg et al. (2002), argue that this development is evidence of money’s inability to provide the ECB with reliable signals.

However, this argument ignores one important element of the ECB’s monetary policy. Even though the monetary analysis is an integral part of the ECB’s monetary policy, the Governing Council, decision-making body of the ECB, follows signals derived from many sources other than money. Therefore, the ECB does not mechanically react to signals coming from their monetary analysis. More than that, the ECB has repeatedly made clear that the monetary pillar represents the long-run analysis, while the short-run developments are accounted for by the economic analysis, the second pillar of the ECB’s two-pillar strategy.

That said, it could be argued that the ECB’s decision to assign, in spite of major oppositions, a prominent role to money supply has indeed been justified. Money does appear to incorporate important implications for the conduct of monetary policy. Even though money is primarily of a long-run importance, it can also have important implications thought the asset price channel.

It is important to note that this is already common practice for most central banks. Even central banks that engage in full-fledged inflation targeting make their decision on the basis of

a diversified pool of indicators including monetary developments. In this case, however, it is questionable whether it is the appropriate policy to deny the importance of monetary aggregates to the public, as has been frequently done by members of the Board of Governors in the Federal Reserve System. Only recently, in March 2006, the Federal Reserve thus stopped publishing M3 claiming that it did not provide any useful information relating to risks to price stability. The ECB, on the other hand, has continued to adhere to its policy which gives money a decisive role in its conduct of monetary policy. It remains to be seen whether the more common inflation targeting or the ECB's alternative, the twin-pillar framework, emerges as the superior monetary policy strategy.

6. Conclusion

This thesis represents an attempt to address the question of how important the monetary analysis is for the assessment of risks to price stability in the euro area. For this purpose, this paper has outlined relevant literature and critically evaluated the ECB’s monetary policy framework. This has been achieved by empirically testing for the correlation between money growth and inflation in the euro area and by putting it into a comparative perspective.

The above analysis points to two main conclusions. First, the results from the correlation analysis are indicative of the fact that money growth and inflation appear to closely move together in the long run. This observation is not only made for the euro area data but also for data retrieved for Japan and the United States. As is predicted by the quantity theory, this relationship intensifies with an increase in the averaging period. In the short to medium run, however, the correlation between money growth and consumer price inflation appears to have decreased over time.

Secondly, and more interestingly, this relationship appears to have weakened in the 1990s. This is in line with findings of other authors failing to establish a correlation between money growth and inflation for low-inflation countries. One possible reason for the development has been shown to be the link between excess money supply and asset prices. Excess money supply in the 1990s appears to have translated into asset price bubbles rather than consumer price inflation.

What do these findings imply with respect to the central question? Theses findings point to the fact that money may contain important information about future risks to price stability especially in the long run. As there are strong evidences suggesting that excess money supply

increasingly translate into asset prices rather than consumer price inflation, it is advisable to carefully consider developments in the money market in the conduct of monetary policy.

Therefore, this paper is supportive of the ECB’s strategic decision to include monetary analysis into their decision-making process. However, this paper has not elaborated on the structure of the ECB’s monetary policy. Clearly, the breakdown of the policy framework into two pillars has implications for the ECB’s ability to effectively communicate its strategic decisions to the public. It appears that this issue has not yet been sufficiently addressed by the academic community. Hence, this discussion is left to future research.

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