Money Demand and the Role of Monetary Indicators in Forecasting Euro Area Inflation

Abstract

This paper examines the forecasting performance of a broad monetary aggregate (M3) in predicting euro area inflation. Excess liquidity is measured as the difference between the actual money stock and its fundamental value, the latter determined by a money demand function. The out-of sample forecasting performance is compared to widely used alternatives, such as the term structure of interest rates. The results indicate that the evolution of M3 is still in line with money demand even in the period of the financial and economic crisis. Monetary indicators are useful to predict inflation at the longer horizons, especially if the forecasting equations are based on measures of excess liquidity. Due to the stable link between money and inflation, central banks should implement exit strategies from the current policy path, as soon as the financial conditions are expected to return to normality.