Ebook Global Liquidity and Asset Prices in a Cointegrated VAR
Studies at country-levels suggest that money does not matter for inflation nor long term interest rates even though economic theory generally prescribes a one-for-one relation in models emphasizing (super-)neutrality; see inter alia Hendry (2001) and Juselius (2007) for empirical analyses of inflation in the UK and Denmark, respectively. However, one reason for this finding may be that it is global liquidity that is important. Also, there is evidence for the existence of one common (worldwide) interest rate and/or inflation rate, see inter alia Ciccarelli and Mojon (2005), which exerts large influence on national rates yet is not controllable by a central bank.
The purpose of this paper is to investigate the existence of a global money market in order to identify potential excess liquidity and analyse its interactions with global inflation and asset prices, as suggested by a number of authors, see Baks and Kramer (1999), Sousa and Zaghini (2004) and Ruffer and Stracca (2006).
Recently, global monetary conditions have received a lot of public interest, from the press, policymakers and market participants alike, but less so from academics. The fact that e.g. the European Central Bank (ECB) is becoming increasingly aware of the potential importance of global liquidity is illustrated by the following excerpts from a speech given by the Vice-President of the ECB, Lucas D. Papademos, on May 35, 2006: Ultimately, global inflation will be determined over the long term by the trend increase in global liquidity.
The relationship between global trend money growth and long-term inflation will depend, however, on the way globalisation affects the rate of expansion of the productive capacity of all economies as well as on its effects on the factors and mechanisms that determine the “velocity of circulation of global money”.
The Economist has recently devoted two Economics Focus articles to the subject (February 8 and June 7, 2007). The second one, “What goes around”, argues that the importance of money depends on whether it is viewed as being determined by supply or demand. Monetarists believe the former where an oversupply of money creates inflation, new-Keynesians, among them many current policymakers, the latter where this is not the case and money may hence be ignored for policy purposes.
The Economist asks whether “the pendulum has swung too far from monetarist overkill to monetary neglect”, and cites Bank of England Governor Mervyn King who argued in a recent lecture that shifts can occur not just in the demand for money, but also in the supply. The topic was also taken up numerous times in the Financial Times. In a comment on June 15, 2007, Martin Wolf discusses whether the recent increase in UK money growth was due to supply or demand reasons and whether the Bank of England should pay attention to it.
Central banks used to monitor money supply, based on the Friedman (1969) idea that “inflation is always and everywhere a monetary phenomenon”, for which the stability of money demand was a necessary prerequisite: if a stable money demand relation exists then the central bank can control inflation via control of the money stock. The money targeting that this idea gave rise to was largely abandoned because empirical analyses often seemed to suggest instability of money demand relations. The Fed argues that money supply is so heavily distorted by offshore holdings and the shift away from bank lending towards securitisation that it is not important for decision-making in an inflation targeting regime.
However, for the euro area stability has been established by a number of authors depending on the methodology employed in the analyses, see inter alia Coenen and Vega (1999) for a euro area money demand analysis. The ECB inherited its monetary policy strategy to a large extent from the Bundesbank which was rather successful in keeping inflation down via control of money supply. Hence, the ECB emphasizes a two-pillar strategy where besides a general assessment of various economic indicators a “prominent role” is assigned to monetary developments.
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