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On the empirical relevance of the Lucas critique: the case of euro area money demand

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Abstract

This paper examines the relevance of the Lucas critique for euro area money demand. Based on the money in the utility function approach, a vector error correction model is specified to investigate the relationship between money and inflation in times of policy shifts. A well defined equation for money demand is obtained. The results indicate that the evolution of M3 is still in line with money demand. In the long run, inflation is affected by asset prices and detrended output. Our results show that the Lucas critique can be refuted in case of euro area money demand for the period of quantitative easing. Thus, the estimated money demand equation provides reliable information for the conduct of future monetary policy.

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Notes

  1. The DF-GLS test is more efficient than the standard ADF test in estimating the deterministic terms. See Elliott, Rothenberg and Stock (1996). The lag lengths for the unit root and cointegration tests is determined by the Akaike criterion. For unit root and cointegration testing see Kirchgässner, Wolters and Hassler (2013).

  2. Interestingly Hendry and Doornik (1994) have found similar long run relationships in a system for UK M1.

  3. The marginal model is estimated for the 2002Q1–2011Q4 sample, as house prices did not affect money demand in earlier periods.

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Acknowledgments

The authors would like to thank two anonymous referees for their comments and suggestions. They have substantially improved the paper.

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Authors and Affiliations

  1. German Institute for Economic Research (DIW Berlin), Mohrenstr. 58, 10117, Berlin, Germany

    Christian Dreger

  2. Freie Universität Berlin, Boltzmannstr. 20, 14195, Berlin, Germany

    Jürgen Wolters

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  1. Christian Dreger
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  2. Jürgen Wolters
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Correspondence to Christian Dreger.

Additional information

This paper is an extended and updated version of Dreger and Wolters (2011b): Money and inflation in the euro area during the financial crisis, DIW Discussion Paper 1131.

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Dreger, C., Wolters, J. On the empirical relevance of the Lucas critique: the case of euro area money demand. Empirica 43, 61–82 (2016). https://doi.org/10.1007/s10663-015-9289-z

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