Money Growth and Inflation in the Euro Area: A Time‐Frequency View
| Date | 01 December 2012 |
| DOI | http://doi.org/10.1111/j.1468-0084.2011.00680.x |
| Author | António Rua |
| Published date | 01 December 2012 |
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OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 74, 6 (2012) 0305-9049
doi: 10.1111/j.1468-0084.2011.00680.x
Money Growth and Inflation in the Euro Area:
A Time-Frequency View
Ant ´
onio Rua
Banco de Portugal, Economic Research Department, Av. Almirante Reis, 71, 1150-012 Lisbon,
Portugal; ISEG, Technical University of Lisbon (e-mail: antonio.rua@bportugal.pt)
Abstract
This article provides new insights on the relationship between money growth and inflation
in the euro area over the last 40 years. This highly relevant link for the European Central
Bank monetary policy strategy is assessed using wavelet analysis. The findings indicate
a stronger link between inflation and money growth at low frequencies over the whole
sample period. At the typical business cycle frequency range the link is only present until
the beginning of the 1980s. Moreover, there seems to be a recent deterioration of the
leading properties of money growth with respect to inflation in the euro area.
I. Introduction
The goal of the European Central Bank (ECB) is to maintain price stability, defined as a
year-on-year increase in the Harmonised Index of Consumer Prices for the euro area below,
but close to, 2% over the medium term. The assessment of risks to price stability is based
on the so-called two-pillar framework. The first pillar relies on economic analysis, where
the focus is on real activity and financial conditions in the economy, to identify short-
to medium-term risks. The second pillar refers to monetary analysis to assess medium-to
long-term developments in inflation. Hence, for tracking shorter-run fluctuations of infla-
tion, the ECB puts emphasis on the economic analysis while for medium-to long-term
trends the focus is on money growth. In this respect, the monetary aggregate M3 has a
prominent role in the ECB’s monetary policy strategy. One of the reasons for the key
role of M3 growth in the ECB’s monetary policy framework relates to its leading proper-
ties regarding inflation in the euro area. Nicolleti-Altimari (2001) and Trecroci and Vega
(2002) show supporting evidence of such relationship but several authors have argued
that such evidence does not hold with more recent data (see, e.g. Hofmann, 2006; Alves,
Marques and Sousa, 2007; Kahn and Benolkin, 2007). In other words, M3 may be losing
its information content about future price developments in the euro area.
Lucas (1980) pioneering work highlighted the importance of the frequency level when
assessing the link between money growth and inflation. The idea that the determinants of
JEL Classification numbers: C40, E30, E40, E50.
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