Testing for the stability of money demand in Italy: has the Euro influenced the monetary transmission mechanism?

Abstract

Stability of money demand is a crucial issue for the efficacy of monetary policy. This is particularly true in the presence of significant exogenous shocks to the monetary system. By implementing the most recent econometric testing procedures, this article intends to investigate the consistency of the stability of money demand in Italy, one of the larger European Monetary Union (EMU) countries, before and after the EMU. Among others, the objective is, indeed, to ascertain the effect of a change in the currency regime on the monetary aggregates and to provide a valid empirical model which is a viable tool for policy performance.

Keywords:

• money demand
• ARDL model
• Kalman filter
• central banks

JEL Classification:

• E41
• C22
• E58

Notes

¹Angelini et al. (1993) and Juselius (1998).

²Fanelli and Paruolo (1999) and Rinaldi and Tedeschi (1996).

³These dummies are defined as one in the specified period and zero elsewhere. They are: 1989:03_01, dummy1(89), 1996:01_03, dummy2(96), 2000:01_04, dummy3(00), 2005:04_01, dummy4(05) for M2 and 1991:03_02, dummy5(91), 2003:01_03 and dummy6(03) for M3. We also identify the break point 2006_04 on which, however, due to an insufficient number of observations we cannot run significance test.

⁴Pesaran et al. (2001, p. 296).

⁵Pesaran et al. (2001) tabulate two sets of asymptotic critical values to provide critical value bounds for all classifications of the regressors into pure I(1), purely I(0) or mutually cointegrated.

⁶Since the variable Ex is defined according to the International Monetary Fund (IMF) classification as number of units of domestic currency per US dollar, an increase in Ex raises the value of the foreign assets in terms of domestic currency. If this increase is perceived as an increase in wealth, then the demand for domestic money increases yielding a positive estimate of the coefficient of Ex. However, if an increase in Ex induces an expectation of further depreciation of the domestic currency, public may hold less of domestic currency and more of foreign currency. In this case, the estimated coefficient is expected to have a negative sign.

⁷Harvey (1989, p. 10).

⁸For a more complete explanation of the Kalman filter approach, the state space form and the measurement and transition equations, see Harvey (1989).