Non-Linear Dynamics in the Euro Area Demand for M1

Abstract

This paper investigates possible non-linearities in the dynamics of the euro area demand for the narrow aggregate M1. A long-run money demand relationship is firstly estimated over a sample period covering the last three decades. While the parameters of the relationship are jointly stable, there are indications of non-linearity in the residuals of the error-correction model. This non-linearity is explicitly modelled using a fairly general Markov switching error-correction model with satisfactory results. The empirical findings of the paper are consistent with theoretical predictions stemming from buffer stock and target-threshold models and with analogous empirical evidence for European countries and the US.