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Keywords:

  • financial assets;
  • money demand;
  • stability;
  • substitution effect

ABSTRACT

This paper sets out to re-examine the money demand function for the euro area. Traditional specifications often yield unsatisfactory results: instability of short and long-term coefficients; relatively large differences between estimated and actual value of variables; and significant changes in the number of long-term relationships, etc. Using a standard Vector Error Correction Model, we find that the usual specification is indeed unstable. However, introducing a European equity price gives rise to a more stable system. Furthermore, recursive estimates confirm the relative stability of long-term coefficients. Estimates of the real money gap, based on the money demand equation including equity prices, point to moderate, albeit persistent, excess liquidity in the euro area in recent years. The real money gap contains information about future inflation but this content may have diminished since 2001.