Monetary Analysis: Tools and Applications

First ECB Central Banking Conference

November 2000, Frankfurt, Germany

Monetary Analysis: Tools and Applications

Editors: Hans-Joachim Kl?ckers

Caroline Willeke Lex Hoogduin Julian Morgan Bernhard Winkler

Published by: ? European Central Bank, August 2001

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Copies of the individual articles can also be downloaded from the ECB's website.

The views expressed in this publication are those of the authors and not necessarily those of the ECB. No responsibility for them should be attributed to the ECB or to any of the other institutions with which the authors are affiliated.

All rights reserved by the authors.

Editors: Hans-Joachim Kl?ckers Caroline Willeke

Typeset and printed by: Druckhaus Thomas M?ntzer GmbH

ISBN 92-9181-148-3

Table of Contents

Foreword "The importance of monetary analysis" O. Issing (European Central Bank) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Preface H.-J. Klo? ckers (European Central Bank) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Summary "Monetary analysis: tools and applications" H. Pill (European Central Bank) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 "Uncertainty and multiple perspectives" J. Selody (Bank of Canada) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 "The role of M3 in the policy analysis of the Swiss National Bank" T. Jordan, M. Peytrignet and Georg Rich (Swiss National Bank) . . . . . . . . . . . . . . . . 47 "Money and credit in an inflation-targeting regime: The Bank of England's Quarterly Monetary Assessment" A. Hauser (Bank of England) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 "Money and inflation: the role of information regarding the determinants of M2 behaviour" A. Orphanides and R. D. Porter (Board of Governors of the Federal Reserve System) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 "The impact of financial anxieties on money demand in Japan" T. Kimura (Bank of Japan) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 "Framework and tools of monetary analysis" K. Masuch, H. Pill and C. Willeke (European Central Bank) . . . . . . . . . . . . . . . . . . . 117 "Monetary analysis in the Bank of Italy prior to EMU: The role of real and monetary variables in the models of the Italian economy" F. Altissimo, E. Gaiotti and A. Locarno (Banca d'Italia) . . . . . . . . . . . . . . . . . . . . . . . 145 "The role of the analysis of the consolidated balance sheet of the banking sector in the context of the Bundesbank's monetary targeting strategy prior to Stage Three" J. Reischle (Deutsche Bundesbank) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

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Table of Contents

"The integration of analysis of extended monetary and credit aggregates in the experience of the Banque de France" F. Drumetz and I. Odonnat (Banque de France) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

"Flow of funds analysis in the experience of the Banco de Espan~ a" J. Pen~ alosa and T. Sastre (Banco de Espan~ a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

List of Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223

Foreword

The importance of monetary analysis

Otmar Issing

Member of the Executive Board of the European Central Bank

These days, few economists would disagree with the statement that inflation is a monetary phenomenon in the long run. Indeed, this statement is one of the central tenets of economic theory. The long-run relationship between money and prices has been confirmed by an impressive number of empirical studies, both across countries and across time. Moreover, the ability to implement monetary policy ultimately hinges on a central bank's monopoly control over the creation of base money. Given the fundamental money-prices relationship and their monopoly power over the legal tender, the monetary authorities have a natural interest in monetary developments. At a more practical level, monetary data are collected in a timely manner and are more accurate than many other economic indicators. All these factors explain why money plays a prominent role in monetary policy-making and thus why the monetary analysis undertaken at central banks is both necessary and important.

The monetary policy strategy of the ECB recognises the monetary nature of inflation by assigning a prominent role to money in the formulation of monetary policy decisions aimed at the maintenance of price stability. This prominence is signalled by the announcement of a quantitative reference value for the growth rate of the broad monetary aggregate M3. In December 1998 the Governing Council of the ECB has set this reference value at 4 ?% and this value was subsequently confirmed in 1999 and 2000. A detailed analysis of monetary developments with the aim of extracting the information relevant for monetary policy decisions represents the first "pillar" of the ECB's monetary policy strategy. Among other things, this analysis includes an investigation of the deviation of M3 growth from the reference value.

Monetary analysis begins with the very definition of a key monetary aggregate. While it is easy to speak about the "M" which appears in economics textbooks, it is much harder in practice to give a meaningful definition of a monetary aggregate. There is now a consensus that broad aggregates, such as euro area M3, tend to perform better as monetary policy indicators than do narrower measures of money, since they internalise the portfolio shifts pervasive in a world of financial innovation and rapid change. In particular, econometric evidence suggests that euro area M3 both has a stable relationship with the price level in the long run and possesses leading indicator properties for inflation over the medium term. As such, this aggregate has the properties required to define the reference value and thus to signal the prominent role of money in the ECB's monetary policy.

To a large extent, monetary analysis represents the analytical work necessary to determine from the available monetary data the underlying relationship between money

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