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a shift in the volatility of nominal variables occurred in the euro

area over the period 19802007. A dynamic stochastic general

equilibrium model with money is proposed and estimated over dif-

ferent subsamples to assess the drivers of these empirical facts.

Our estimation results and counterfactual exercises provide evi-

dence that a change in the degree of responsiveness of monetary

authorities and the transition from a money growth to an inter-

est rate rule explain much of the observed properties of nominal

variables and their relationships.

Keywords: Quantity theory of money, monetary policy, DSGE

model, Bayesian methods.

JEL: E31, E51, E52.

The empirical breakdown of the quantity theory of money and the radical shift

in the volatility of most macroeconomic data are two prominent stylised facts char-

acterizing the euro area over the period 19802007. Recent literature has focused

on such developments for several OECD countries. For instance, Sargent and Surico

(2011) and Teles and Uhlig (2010) explain the large departures from a unitary money

growth/ination relation by the dependence of the coecient estimate associated

with the regression of the two variables to the policy rule parameters. In more recent

times, the lowination countries should then see the relationship between ination

and the growth rate of money becoming tenuous at best. Other studies, such as

Andres et al. (2006) or Justiniano and Primiceri (2008), suggest that the decline in

macroeconomic volatility over the past thirty years is largely the result of smaller

shocks impinging on the economy (usually called the good luck hypothesis), with

structural changes having played at most a secondary role. There is therefore dis-

agreement about the origin of changes both in the statistical properties of nominal

variables and in their relationships.

In this paper, we argue that a change in the degree of responsiveness of the mon-

etary authorities and the transition from a money growth to an interest rate rule

explain much of the stylised facts. To reach this conclusion, we rst show the signif-

icant dierence in the way monetary policy was conducted pre and postEuropean

Monetary Union (EMU). We then go on to demonstrate that this dierence in policy

behavior allows an understanding of the shift in macroeconomic behavior.

Avouyi-Dovi: Banque de France, 31 rue Croix des Petits Champs, 75049 Paris, France (e-mail:

sanvi.avouyi-dovi@banque-france.fr); Sahuc: Banque de France, 31 rue Croix des Petits Champs, 75049 Paris,

France (e-mail: jean-guillaume.sahuc@banque-france.fr). We are grateful to Christophe Cahn, Patrick Fve,

Benoit Mojon, Christian Pster, Thomas Sargent and Richard Summer for comments. Special thanks to

Julien Matheron, whose suggestions greatly improved the paper. The views expressed herein are those of the

authors and do not reect those of the Banque de France.

1

The intuitions behind this result are as follows. The quantity theory implies that

any change in the monetary aggregate induces a variation in the same direction and

same magnitude of prices and of nominal interest rates. If price stability is the

objective of the monetary authorities, any price increase should result in a sharp

contraction in the money supply. As a consequence, both variances and covariances

between nominal variables decrease. But, implementing price stability or ination

targeting while the underlying theory establishes similar variations between prices

and the monetary aggregate necessarily induces a stronger fall of the covariances.

This mechanical eect blurs the two quantity propositions. In addition, with an

interest elastic demand for real money balances, any shock that aects the path for

expected ination or the real interest rate causes money demand to shift. When

the central bank follows an interest rate rule rather than a money growth rule, the

money stock is endogenous and ination is xed by the policy rule. Money absorbs

the adjustment and the central bank can accommodate this jump in the money stock

almost instantaneously and with little cost. Consequently, the money stock responds

by shifting to clear the money market. It allows to explain why, in an economy with

stochastic ination and an interest rate rule for monetary policy, the money growth

rate is much more variable than the ination rate.

To demonstrate the role of these mechanisms, we consider a structural monetary

model of the business cycle in which money is allowed to play a relevant role. The

model combines a neoclassical growth core with several shocks and frictions. It

includes features such as habit formation, money in the utility, investment adjust-

ment costs, variable capital utilization, monopolistic competition in goods and labour

markets, and nominal price and wage rigidities. We follow the Bayesian approach to

estimate several versions of the model. Unlike all previous papers that use an ad-

hoc calvo-type employment adjustment equation to translate hours worked into the

observed employment series, we directly use a new series of quarterly hours worked

for the euro area. We consider two subsamples: 1980Q11998Q4 in imposing a

money growth rule and 1999Q12007Q4 in imposing an interest rate rule. Indeed,

during the 1980s and 1990s, many European countries have employed either ocial

money growth targets (through a broadly dened monetary aggregate) or exchange

rate policies in order to tie to the Deutschmark within the Exchange Rate Mecha-

nism (Bernanke and Mishkin, 1992). In Germany for instance, the setting of targets

explicitly takes into account the Bundesbanks long-term ination goal, estimated

potential output growth and expected velocity trends, which are combined using the

quantitytheory equation to determine the desired money growth rate. From 1999,

the European Central Bank (ECB) steered shortterm money market rates in order

to inuence the spending decisions of the private sector, monetary and nancial de-

velopments and, ultimately, prices. This change in the monetary policy instrument

follows the idea that money and hence credit does not have any crucial and construc-

tive roles to play in monetary policy design (Woodford, 2008).

1

The money market is

1

The designation monetary policy instrument is a shortcut in macroeconomic modeling to represent in

fact intermediate targets which are variables that are neither under the direct day-to-day control of the

central bank nor are the ultimate goals of policy, but that are used to guide policy. Values for instruments are

usually set so that, given estimates of behavioral parameters such as the interest elasticity of money demand,

intermediate targets for variables are reached in the longer term (quarter-to-quarter or year-to-year).

2

then only useful for determining the supply of money which responds endogenously

to the demand of money. This consensus substituted the one put forward by Milton

Friedman that ination is always and everywhere a monetary phenomenon.

The article is structured as follows. Section I presents the empirical evidence

that motivates the paper. Section II describes the structural model and Section III

describes the estimation procedure and reports the estimation results. Section IV

analyses the drivers of the two stylised facts. A last section concludes.

I. Stylised Facts

A. The empirical breakdown of the quantity theory of money

The quantity theory of money can be expressed in terms of lowfrequency comove-

ments between money growth and ination as well as between money growth and

nominal interest rate. The lowfrequency approach, that does not require a host of

encumbering theoretical or econometric assumptions, is achieved by using a lter

that extracts a longrun signal from time series data. Lucas (1980) has suggested

the following lter (revisited by Whiteman, 1984, and Sargent and Surico, 2011):

x

t

() =

n

k=n

|k|

x

t+k

,

where x

t

is the variable of interest, is a parameter comprised between 0 and 1, and

= (1 )

2

/(1 2

n+1

(1 )) is selected such that the sum of the weights is

equal to 1. As approaches zero, no ltering occurs, while as approaches unity,

the ltered series x

t

() approaches the sample mean of the original series. Following

Lucas, we set = 0.95.

2

Given the size of our sample and the fact that long averaging

does not appear in practice to deliver any greater improvement in t (McCallum and

Nelson, 2010), we set n = 4.

Unit slopes of graphs of long twosided moving averages are used to characterise

the implications of the quantity theory of money. According to this theory, a plot of

ination or nominal interest rates against money growth should produce data points

that lie along a 45degree line.

Figure 1 shows scatter plots of ltered M2 growth, ination and nominal short

term interest rate (see Section III.A for details on the data used in our analysis).

We split the sample in 1999 when the nal stage of the European Economic and

Monetary Union (EMU) was successfully launched. This date ocially translated

regime change in monetary policy in the euro area. During the 1980s and 1990s,

many European countries have either a monetary target (through a broadly dened

monetary aggregate) or exchange rate policies in order to tie to the deutschmark

through the Exchange Rate Mechanism. From 1999, the conversion rates of the

currencies of the 11 members states initially participating in monetary union were

irrevocably xed and the ECB took over responsability for conducting the single

monetary policy in the euro area. The ECB steers shortterm interest rates by

2

Sargent and Surico (2011) have tested other values of without aecting the variability of the elasticity

of money relative to price.

3

signalling its monetary policy stance and by managing the liquidity situation in the

money market.

y = 1.34x - 3.02

0

2

4

6

8

0 2 4 6 8

Money growth

1980-1998

y = 1.38x + 0.15

0

2

4

6

8

10

12

0 2 4 6 8 10 12

Money growth

1980-1998

y = 0.03x + 1.33

0

2

4

6

8

0 2 4 6 8

Money growth

1999-2007

y = -0.12x + 3.07

0

2

4

6

8

0 2 4 6 8

Money growth

1999-2007

Figure 1. Scatter plots of ltered money growth, ination and interest rate

The graphs reveal that the quantity theory of money can be veried or not ac-

cording to the reporting period. The scatters of points corresponding to the period

19801998 show a concentration of points around the diagonal (45degree line), val-

idating the quantity theory of money over that period. This result is conrmed by

calculating the slope of the regression associated with these points: 1.34 for the in-

ation on money growth regression and 1.38 for the interest rate on money growth

regression. This illustrates the fact that periods of sustained high ination are always

accompanied by high growth rates of money, reinforcing the dictum that ination is

always and everywhere a monetary phenomenon. It was in this context that the

architects of the ECB assigned a prominent role to money. In doing so, they wanted

to acquire the credibility of the Bundesbank prior to the adoption of the euro.

But since 1999, the two scatters of points are at, resulting in slopes of the regres-

sion lines close to zero. The quantity theory of money seems to have disappeared

over the recent period. There is a marked deterioration in the ltered series once

the postEMU period is considered. While the ination rate remained practically

constant at the 2% level, the rate of money growth took on an upward trend. This

4

pattern created a divergent gap between the long term component of money growth

and ination after the introduction of the euro.

B. Changes in volatilities

In the period between the mid1990s and 2007, European economies enjoyed one

of the greatest economic growth periods, known as the Great Moderation due to

the low macroeconomic volatility in those years. The high growth rates of economic

variables with low volatility came simultaneously with ination under control and

low interest rates across the board of nancial assets, with practically inexistent risk

premia in many cases as a result of the underassessment of risk.

Table 1 summarises the evidence on volatility changes in ination, interest rate

and money growth by showing their respective standard deviations for the preEMU

and postEMU periods as well as the ratio between the two. We observe two striking

features. First, the volatility of ination and the shortterm interest rate has declined

sharply, by a factor of 3. This resulted from the high credibility achieved by the

ECB in maintaining a low and stable ination rate, in line with its denition of price

stability. Second, the volatility of money growth increased from 0.52 to 0.60.

3

Table 1Standard deviation of quarterly ination, interest rate and money growth (19802007)

PreEMU PostEMU

PostEMU

PreEMU

Ination 0.718 0.189 0.263

Interest rate 0.769 0.236 0.307

Money growth 0.515 0.601 1.167

There are two main reasons underlying this development. From a theoretical point

of view, when the interest rate becomes the monetary instrument, money becomes

endogenous and clears the money market. This property makes it automatically more

volatile to meet money demand. From a cyclical point of view, the emergence of new

nancial players and an array of innovative nancial instruments make the traditional

money supply gures harder to interpret. That increase in the volatility of money

growth is our second piece of evidence pointing to the presence of changes beyond

those that would result from a scaling down of volatility in all nominal variables.

II. A mediumscale model for the euro area

The present section describes our microfounded model of the Euro area economy,

which is close to Christiano, Eichenbaum, and Evans (2005) and Smets and Wouters

(2007). The model combines a neoclassical growth core with several shocks and fric-

tions. It includes features such as habit formation, investment adjustment costs,

variable capital utilization, monopolistic competition in goods and labour markets,

3

This increase in volatility is valid whatever the choice of the monetary aggregate (see Appendix A1).

5

and nominal price and wage rigidities. The economy is populated by ve classes of

agents: producers of a nal good, intermediate goods producers, households, em-

ployment agencies and the government. We adopt the specication investigated by

Justiniano, Primiceri and Tambalotti (2010), except that (i) we allow for money in

the utility function and (ii) we introduce two types of monetary policy rules.

A. Household sector

L:iio.:i:1 .oi:cii

Each household indexed by j [0, 1] is a monopolistic supplier of specialised labor

N

j,t

. At every point in time t, a large number of competitive employment agencies

combine households labor into a homogenous labor input N

t

sold to intermediate

rms, according to

(1) N

t

=

__

1

0

N

j,t

1

w,t

dj

_

w,t

,

Prot maximization by the perfectly competitive employment agencies implies the

labor demand function

(2) N

j,t

=

_

W

j,t

W

t

_

w,t

w,t

1

N

t

,

where W

j,t

is the wage paid by the employment agencies to the household supplying

labor variety j, while

(3) W

t

__

1

0

W

j,t

1

w,t1

dj

_

w,t1

is the wage paid by intermediate rms for the homogenous labor input sold to them

by the agencies.

w,t

measures the substitutability across labor varieties and its steadystate is the

desired steadystate wage markup over the marginal rate of substitution between

consumption and leisure. It is assumed to follow an ARMA(1,1) process in order to

capture the moving average, high frequency component of wages,

log (

w,t

) = (1

w

) log (

w

)+

w

log (

w,t1

)+

w,t

w,t1

,

w,t

i.i.d.N

_

0,

2

w

_

Hoiioi iniiini:ci

The preferences of the jth household are given by

(4) E

t

s=0

b,t+s

_

log (C

t+s

hC

t+s1

) +

m,t+s

1

z,t+s

1

_

M

t+s

P

t+s

_

1

N

1+

j,t+s

1 +

_

,

6

where E

t

denotes the mathematical expectation operator conditional upon informa-

tion available at t.

4

C

t

denotes consumption, M

t

/P

t

represents real balances, N

j,t

is

labor of type j. The parameter is the subjective discount factor, h [0, 1] denotes

the degree of habit formation, is related to the interest rate elasticity of the money

demand, and > 0 is the inverse of the Frisch elasticity.

b,t

and

m,t

are a dis-

turbance of the discount factor and a velocity shock respectively, evolving according

to

log (

b,t

) =

b

log (

b,t1

) +

b,t

,

b,t

i.i.d.N

_

0,

2

b

_

,

and

log (

m,t

) =

m

log (

m,t1

) +

m,t

,

m,t

i.i.d.N

_

0,

2

m

_

.

As we explain below, households are subject to idiosyncratic shocks about whether

they are able to reoptimise their wage. Hence, the above described problem makes

the choices of wealth accumulation contingent upon a particular history of wage

rate decisions, thus leading to households heterogeneity. For the sake of tractability,

we assume that the momentary utility function is separable across consumption,

real balances and leisure. Combining this with the assumption of a complete set of

contingent claims market, all the households will make the same choices regarding

consumption and money holding, and will only dier by their wage rate and supply

of labor. This is directly reected in our notations.

Household js period budget constraint is given by

P

t

(C

t

+I

t

) +T

t

+B

t

+M

t

R

t1

B

t1

+M

t1

+Q

j,t

+D

t

+W

j,t

N

j,t

+R

k

t

u

t

K

t1

P

t

(u

t

)

K

t1

, (5)

where I

t

is investment, T

t

denotes nominal lumpsum taxes (transfers if negative),

B

t

is the one-period riskless bond, R

t

is the nominal interest rate on bonds, Q

j,t

is

the net cash ow from households j portfolio of state contingent securities, D

t

is

the equity payout received from the ownership of rms, and R

k

t

is the rental rate of

capital. The capital utilization rate u

t

transforms physical capital

K

t

into the service

ow of eective capital K

t

according to

(6) K

t

= u

t

K

t1

,

and the eective capital is rented to intermediate rms at the nominal rental rate

r

k

t

. The costs of capital utilization per unit of capital is given by the convex function

(u

t

). We assume that u = 1, (1) = 0, and we dene

(1) /

(1)

1 +

(1) /

(1)

.

4

As tested by Ireland (2004) and Andrs et al. (2006), the assumption of non separable preferences in the

utility function is rejected.

7

Later, we estimate

u

rather than the elasticity

(1) /

issues.

The physical capital accumulates according to

(7)

K

t

= (1 )

K

t1

+

i,t

_

1 S

_

I

t

I

t1

__

I

t

,

where is the depreciation rate of capital, and S (.) is an adjustment cost function

which satises S (

z

) = S

(

z

) = 0 and S

(

z

) =

k

> 0,

z

is the steadystate

growth rate of technology, and

i,t

is an investment shock, evolving according to

log (

i,t

) =

i

log (

i,t1

) +

i,t

,

i,t

i.i.d.N

_

0,

2

i

_

.

Households set nominal wages according to a staggering mechanism. In each period,

a fraction

w

of households cannot choose its wage optimally, but adjusts it to keep

up with the increase in the general wage level in the previous period according to the

indexation rule

(8) W

j,t

=

z

1

w

w

t1

W

j,t1

,

where

t

P

t

/P

t1

represents the gross ination rate, is steadystate (or trend)

ination and the coecient

w

[0, 1] is the degree of indexation to past wages.

The remaining fraction of households chooses instead an optimal wage, subject to

the labor demand function (2).

B. Business sector

Fi:.i ooo inocin

At every point in time t, a perfectly competitive sector produces a nal good Y

t

by combining a continuum of intermediate goods Y

t

(i), i [0, 1], according to the

technology

(9) Y

t

=

__

1

0

Y

i,t

1

p,t

di

_

p,t

,

Final good producing rms take their output price, P

t

, and their input prices, P

i,t

,

as given and beyond their control. Prot maximization implies the following Euler

equation

(10) Y

i,t

=

_

P

i,t

P

t

_

p,t

p,t1

Y

t

.

Integrating (10) and imposing (9), we obtain the following relationship between

8

the nal good and the prices of the intermediate goods

(11) P

t

__

1

0

P

i,t

1

p,t

1

di

_

p,t1

.

p,t

measures the substitutability across dierentiated intermediate goods and its

steady state is then the desired steadystate price markup over the marginal cost of

intermediate rms. It is assumed to follow an ARMA(1,1) process in order to capture

the moving average, high frequency component of ination

log (

p,t

) =

_

1

p

_

log (

p

) +

p

log (

p,t1

) +

p,t

p,t1

,

p,t

i.i.d.N

_

0,

2

p

_

.

I:1in:ii.1i-ooo iin:

Intermediate good i is produced by a monopolist rm using the following produc-

tion function

(12) Y

i,t

= K

i,t

[Z

t

N

i,t

]

1

Z

t

F,

where denotes the capital share, K

i,t

and N

i,t

denote the amounts of capital and

eective labor used by rm i, F is a xed cost of production that ensures that prots

are zero in steady state, and Z

t

is an exogenous laboraugmenting productivity factor

whose growthrate, denoted by

z,t

Z

t

/Z

t1

, evolves according to

log (

z,t

) =

z,t

,

z,t

i.i.d.N

_

0,

2

z

_

.

In addition, we assume that intermediate rms rent capital and labor in perfectly

competitive factor markets.

Intermediate rms set prices according to a staggering mechanism. In each period,

a fraction

p

of rms cannot choose its price optimally, but adjusts it to keep up

with the increase in the general price level in the previous period according to the

indexation rule

(13) P

i,t

=

1

p

p

t1

P

i,t1

,

where the coecient

p

[0, 1] indicates the degree of indexation to past prices. The

remaining fraction of rms chooses its price P

i,t

optimally, by maximizing the present

discounted value of future prots

(14) E

t

s=0

(

p

)

s

t+s

t

_

p

t,t+s

P

i,t

Y

i,t+s

_

W

t+s

N

i,t+s

R

k

t+s

K

i,t+s

__

,

where

(15)

p

t,t+s

=

_

s

=1

1

p

p

t+v1

s > 0

1 s = 0

,

9

subject to the demand from nal goods rms given by equation (10) and the produc-

tion function (12).

t+s

is the marginal utility of consumption for the representative

household that owns the rm.

C. Public sector

We assume that public spending G

t

is set according to

(16) G

t

=

_

1

1

g,t

_

Y

t

,

In order allow extensive feedback from endogenous variables to money growth,

monetary policy is set according to the following rule

(17)

t

=

t1

_

_

_

Y

t

z

Y

t1

_

y

_

(1

r,t

,

where

r,t

is a monetary policy shock, evolving according to

log (

r,t

) =

r,t

,

r,t

i.i.d.N

_

0,

2

r

_

.

We consider two types of monetary policy rules depending on the instrument the

central bank uses. The rst is a money growth rule according to which the central

bank adjusts smoothly the growth rate of money,

t

= M

t

/ (

z

M

t1

), in response

to movements in ination and output growth. The second is a Taylor rule according

to which the shortterm nominal interest rate,

t

= R

t

/R, is adjusted smoothly in

response to movements in ination and output growth.

D. Market clearing

Market clearing conditions on nal goods market are given by

Y

t

= C

t

+I

t

+G

t

+(u

t

)

K

t1

, (18)

p,t

Y

t

=

_

u

t

K

t1

_

[Z

t

N

t

]

1

Z

t

F, (19)

where

p,t

=

_

1

0

_

P

i,t

Pt

_

p,t

p,t1

di is a measure of the price dispersion.

III. Quantitative analysis

In this section, our formal econometric procedure is expounded. We then discuss

our results and check the ability of our models to reproduce the two stylised facts.

A. Data and econometric approach

The quarterly euro area data used in our empirical analysis are extracted from

the AWM database compiled by Fagan et al. (2005), except the monetary aggregate

10

and hours worked. Regarding nominal variables, ination is measured by the rst

dierence of the logarithm of GDP deator (YED), the shortterm nominal interest

rate is a three month rate (STN), and money growth is the rst dierence of the

logarithm of M2.

-1

0

1

2

3

4

Inflation

0

1

2

3

4

5

Short-term interest rate

0

1

2

3

4

M2 growth

-2

-1

0

1

2

Output growth

-2

-1

0

1

2

Consumption growth

-4

-2

0

2

4

Investment growth

-2

-1

0

1

2

Wage growth

-2

-1

0

1

Growth of total hours worked

Figure 2. Quarterly data for the euro area (1980Q12007Q4)

11

Regarding real variables, output growth is the rst dierence of the logarithm

of real GDP (YER), consumption growth is the rst dierence of the logarithm of

real consumption expenditures (PCR), investment growth is the rst dierence of

the logarithm of real gross investment (ITR), wage growth is the rst dierence of

the logarithm of nominal wage (WRN) divided by GDP deator, and growth of

total hours worked are the rst dierence of the logarithm of total hours worked.

Real variables are divided by the working age population, extracted from the OECD

Economic Outlook. Ohanian and Rao (2012) have build a new dataset of quarterly

hours worked for 14 OECD countries. We have then made an average of their series

of hours worked for France, Germany and Italy to obtain a series of total hours for

the euro area. Interestingly, the series thus obtained is very close to that provided by

the ECB on the common sample, i.e. 1995Q12007Q4. The series for M2 is available

from the ECB statistical warehouse since 1980Q1, which is therefore the starting

date for our analysis. The data are reported in Figure 2.

We are interested in two versions of the loglinearised model:

5

A model with a money growth rule (MG), estimated from 1980Q1 to 1998Q4;

A model with an interest rate rule (IR), estimated from 1999Q1 to 2007Q4.

The choice of the nal date prevents our estimates from being distorted by the

nonlinearities induces by the dierent size of the shocks and the zero lower

bound on nominal interest rates.

We follow the Bayesian approach to estimate the models (see An and Schorfheide,

2007, for an overview). Letting denote the vector of structural parameters to be

estimated and S

T

{S

t

}

T

t=1

the data sample, we use the Kalman lter to calcu-

late the likelihood L(, S

T

), and then combine the likelihood function with a prior

distribution of the parameters to be estimated, (), to obtain the posterior distrib-

ution, L(, S

T

)(). Given the specication of the model, the posterior distribution

cannot be recovered analytically but may be computed numerically, using a Monte-

Carlo Markov Chain (MCMC) sampling approach. More specically, we rely on the

MetropolisHastings algorithm to obtain a random draw size of 1,000,000 from the

posterior distribution of the parameters.

We use growth rates for the non-stationary variables in our data set (output, con-

sumption, investment, money and the real wage) and express gross ination, gross

interest rates and the rst dierence of the logarithm of hours worked in percent-

age deviations from their sample mean. We write the measurement equation of the

Kalman lter to match the eight observable series with their model counterparts.

Thus, the statespace form of the model is characterised by the state equation

X

t

= A()X

t1

+B()

t

,

t

i.i.d.N (0,

) ,

where X

t

is a vector of endogenous variables, and

t

is a vector of innovations to the

eight structural shocks; and the measurement equation

S

t

= C() +DX

t

+

t

,

t

i.i.d.N (0,

) ,

5

See Appendix A2 for further details on the procedure used to induce stationarity.

12

where S

t

is a vector of observable variables, that is,

S

t

= 100[log Y

t

, log C

t

, log I

t

, log (W

t

/P

t

) , log N

t

, log (M

t

/P

t

) ,

t

, R

t

];

and

t

is a vector of measurement errors.

The model contains nineteen structural parameters, excluding the parameters rela-

tive to the exogenous shocks. We calibrate six of them : the discount factor is set to

0.99, the capital depreciation rate to 0.025, the capital share in the CobbDouglas

production function is set to 0.30 (McAdam and Willman, 2008), the steadystate

price and wage markups

p

and

w

are set to 1.20 and 1.35 respectively (Everaert and

Schule, 2008), and the steadystate share of government spending in output is set to

0.20 (the average value over the sample period). The remaining thirteen parameters

are estimated. The prior distribution is summarised in Table 2. Our choices are in

line with the literature, especially with Smets and Wouters (2007), Sahuc and Smets

(2008) and Justiniano et al. (2010). As regards the interest rate elasticity of the

money demand , we assign it a Gamma density prior with mean 10 and standard

deviation 5.

B. Estimation results

The estimation results for the two models are summarised in the righthand side

panels of Table 2, where the posterior mean and the 90% condence interval are

reported. Several results are worth commenting on. First, as regards the interest

rate elasticity of the money demand, , we nd a value of 22 for the model with a

money growth rule and of 17 for the model with an interest rate rule. Such values,

combined with the respective steadystate values of ination and of economic growth,

imply an interest semi-elasticity of money demand at 1.59 for the rst sub-sample

and at 2.92 for the second one

6

.

As regards the behavior of households, we rst nd that the habit persistence

parameter h diers between periods, indicating that the reference for current con-

sumption was about 42% (resp. 68%) of past consumption from 1980 to 1998 (resp.

from 1999 to 2007). Second, the inverse of the elasticity of labor disutility, , is

similar across the samples and is approximately equal to 2.2. The wage indexation

parameter is

w

0.40 in the two model versions, slightly higher than the price in-

dexation parameter

p

0.35. This reects a now standard result that the euro area

data do not require too high a degree of price indexation. The probability that rms

are not allowed to re-optimise their price is

p

= 0.89 (resp.

p

= 0.71) in the rst

sub-sample (resp. in the second sub-sample). It implies an average duration of price

contracts of about 36 months on the period 19801998 and 14 months on the period

19992007. The probability of no wage change is

w

0.70, implying an average

duration of wage contracts of about 13 months. All these numbers are consistent

with the results reported in the survey done by Druant et al. (2012).

6

These values are close to the point estimates found in recent papers, see for instance Reynard (2004) and

Dorich (2009).

13

Table 2Prior Densities and Posterior Estimates

Parameter Prior Posterior

Model with a money growth rule

Sample: 1980Q11998Q4

Model with an interest rate rule

Sample: 1999Q12007Q4

h B[0.60,0.10] 0.417 [0.309,0.525] 0.677 [0.568,0.789]

G[10.00,5.00] 22.213 [16.113,28.049] 17.555 [9.992,25.047]

G[2.00,0.75] 2.139 [0.937,3.277] 2.234 [1.028,3.410]

u

B[0.50,0.10] 0.650 [0.536,0.769] 0.719 [0.604,0.838]

k

G[4.00,1.00] 3.418 [2.188,4.601] 4.447 [2.837,6.059]

log (

z

) G[0.50,0.10] 0.367 [0.288,0.447] 0.447 [0.347,0.544]

p

B[0.66,0.10] 0.896 [0.870,0.923] 0.712 [0.607,0.827]

w

B[0.66,0.10] 0.702 [0.587,0.813] 0.693 [0.584,0.801]

p

B[0.50,0.15] 0.338 [0.139,0.536] 0.361 [0.131,0.579]

w

B[0.50,0.15] 0.404 [0.198,0.609] 0.371 [0.166,0.575]

N[0.00,0.50]

G[2.00,0.50]

0.655

[0.501,0.811]

1.742

[1.344,2.128]

y

N[0.00,0.50]

G[0.125,0.10]

1.057

[1.456,0.649]

0.198

[0.075,0.315]

w

B[0.60,0.20] 0.959 [0.928,0.989] 0.698 [0.499,0.909]

b

B[0.60,0.20] 0.625 [0.482,0.765] 0.309 [0.119,0.493]

m

B[0.60,0.20] 0.318 [0.154,0.477] 0.959 [0.924,0.996]

x

B[0.60,0.20] 0.158 [0.048,0.260] 0.616 [0.432,0.809]

p

B[0.60,0.20] 0.643 [0.437,0.861] 0.689 [0.479,0.909]

p

B[0.60,0.20]

B[0.60,0.20]

B[0.60,0.20]

0.982

0.789

0.589

[0.967,0.996]

[0.789,0.671]

[0.327,0.963]

0.969

0.619

0.506

[0.936,0.999]

[0.405,0.842]

[0.165,0.785]

w

IG[0.25,2.00] 0.161 [0.120,0.199] 0.172 [0.131,0.211]

b

IG[0.25,2.00] 0.095 [0.066,0.121] 0.085 [0.057,0.113]

m

IG[0.25,2.00] 0.928 [0.804,1.051] 0.996 [0.835,1.115]

x

IG[0.25,2.00] 0.719 [0.606,0.834] 0.247 [0.168,0.322]

p

IG[0.25,2.00] 0.165 [0.121,0.209] 0.155 [0.113,0.198]

z

IG[0.25,2.00] 0.705 [0.608,0.795] 0.543 [0.441,0.644]

g

IG[0.25,2.00] 0.416 [0.360,0.472] 0.272 [0.219,0.324]

r

IG[0.25,2.00] 0.352 [0.251,0.449] 0.113 [0.088,0.138]

Note: This table reports the prior distribution, the mean and the 90 percent condence interval

(within square brackets) of the estimated posterior distribution of the structural parameters.

14

The policy parameters

_

,

y

_

(0.66, 1.06) and

the period 19801998, money growth was moving smoothly with a little weight on

ination and a larger weight on output growth. As expected, the gure is dierent

for the period 19992007. Indeed, the policy parameters

_

,

y

_

(1.74, 0.20) and

= 0.81 indicate that the ECB acts very gradually with a large weight on ination,

consistent with its mandate.

The estimates of the serial correlation of shocks display a dierence between the two

samples. For instance, the serial correlation of wage markup and preference shocks is

stronger in the rst subsample while the serial correlation of velocity and investment

shocks is higher in the second subsample. Finally, notice that the standard error of

the velocity shock is slightly higher in the recent period.

C. Model evaluation

In this subsection, we analyze the performance of the models at replicating the two

stylised facts. To do so, we generate 1000 samples of size consistent with the empirical

counterpart (after a burn-in period of 1000 observations) from the two model versions

using the posterior estimates. For each simulation, we compute the lowfrequency

relationships between ltered money growth, ination and the nominal interest rate.

The results of this exercise are displayed in Figure 3.

0

10

20

30

40

50

60

70

80

0.78 0.83 0.87 0.92 0.97

Inflation on money growth

0

10

20

30

40

50

60

70

80

90

0.51 0.58 0.66 0.73 0.80

Interest rate on money growth

Panel a. Model with a money growth rule (1980Q11998Q4)

0

10

20

30

40

50

60

70

80

-0.23 -0.15 -0.06 0.03 0.11

Inflation on money growth

0

10

20

30

40

50

60

70

80

90

-0.37 -0.25 -0.12 0.00 0.12

Interest rate on money growth

Panel b. Model with an interest rate rule (1999Q12007Q4)

Figure 3. Simulated coecients of the regressions on ltered data

15

First, we observe that the model with a money growth rule (period 19801998)

replicates quite well the two quantity theory propositions: the mean of the coecient

of the regression of ination on money growth is 0.91 and the mean of the coecient

of the regression of the nominal interest rate on money growth is 0.70 (panel a).

Second, the model with an interest rate rule (period 19992007) also reproduces the

empirical fact of absence of quantity theory. Indeed, the mean of the coecient of

the regression of ination on money growth is 0.04 and the mean of the coecient

of the regression of the nominal interest rate on money growth is 0.03 (panel b).

This exercise conrms that our structural model is able to reproduce the rst stylised

fact.

Let us focus now on the second stylised fact, the shift in macroeconomic volatility.

To do so, we use the simulated data and compute their standard deviations. Table

3 reports the simulated standard deviation for the two models. Given that Bayesian

estimation operates by trying to match the entire autocovariance function of the

data, there is a tension between matching standard deviations and other second

moments of the data. Therefore, the researcher should not expect perfect accounting

of the observed volatilities. Despite this, the models are able to replicate to a large

extent the empirical evidence at hand. Indeed, the theoretical framework successfully

delivers the dierences in size of the slowdown in the volatility of ination and nominal

interest rate, as observed in the data.

Table 3Model Fit: Standard Deviations

1980Q11998Q4 1999Q12007Q4

Data Model (MG) Data Model (IR)

Mean 90% CI Mean 90% CI

Ination 0.718 0.736 [0.551,0.954] 0.189 0.248 [0.186,0.314]

Interest rate 0.769 0.784 [0.627,0.979] 0.236 0.227 [0.174,0.310]

Money growth 0.515 0.674 [0.555,0.830] 0.601 0.805 [0.727,0.912]

Note: For each 1000th parameter draw from the posterior distribution, 1000 samples with the same

length as the data are generated (after discarding 1000 initial observations). This table reports the

mean and the 90 percent condence interval (within square brackets).

However, the modelimplied standard deviations for money growth is larger than

that in the data. The reason is that the model imposes a common trend between

output and money. This constraint is quite strong since the two series show dier-

ent trends. To compensate, the volatility of money growth should increase. This

dierence in trends is identical in both models. Thus, it does not alter the relative

dierence between the two variances of money growth. We can conclude that the

model proposed in this paper is a good candidate for analyzing the two stylised facts.

16

IV. Assessing the drivers of both stylised facts

In this section, we analyze the model drivers of both the breakdown of the two

quantity propositions and the change in the macroeconomic volatility. Our aim is to

understand whether changes in monetary policy, shocks or private sector coecients

across subsamples are responsible for the two empirical facts. To do so, we start

from the model (MG) hereafter referred to as benchmark and perform two sets

of counterfactual exercises. The rst set is summarised below:

Counterfactual (1): we analyze the role played by monetary policy (shifts in

the coecients and the instrument).

Counterfactual (2): we study the relevance of the good luck hypothesis, i.e. the

role of the size and source of the shocks hitting the economy.

Counterfactual (3): we assess the relevance of a change in the structure of the

economy (i.e. a modication of preferences and technology).

For illustration purposes, let us consider Counterfactual (1). We proceed by per-

forming 1000 simulations for each 1000th draw in the posterior simulator using the

following procedure. We simulate the model economy for 80 periods (after a burn-in

of 1000 observations) using the parameter estimates vector characterizing the 1980

1998 period but with the estimated interest rate rule obtained on the 19992007

sample period. We then compute (i) the low frequency relationships between ltered

money growth, ination and the nominal interest rate, and (ii) the standard devia-

tion of the endogenous variables. The other counterfactual exercises are performed

in the same way.

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

-0.2 0 0.2 0.4 0.6 0.8 1 1.2

Inflation on money growth

(1)

(2)

(3)

(6)

(4)

(5) (IR)

(MG)

Figure 4. Coecients of the regressions on ltered data: Counterfactuals.

Note: The two crosses correspond to the models (MG) and (IR); The

bullets correspond to the counterfactuals 16.

17

Figure 4 reports the lowfrequency relationships between ltered money growth,

ination and the nominal interest rate. First, there is no signicant dierence be-

tween Counterfactual (3) and the benchmark, indicating that the potential changes

in preferences and technology by the private sector did not inuence the two quantity

propositions. Second, although the good luck hypothesis Counterfactual (2) does

not modify the relationship between money growth and nominal interest rate, that

between money growth and ination deteriorates. Indeed the slope of the regression

of money growth on ination changes from 0.909 to 0.562. Finally, Counterfactual

(1) clearly shows that monetary policy is the key factor explaining the breakdown

of the quantity theory of money. The slope of the regression of money growth on

ination (resp. money growth on nominal interest rate) changes from 0.909 (resp.

0.702) to 0.286 (resp. 0.172).

Table 4 reports the standard deviations generated in each counterfactual simu-

lation. The simulations lead to conclusions in line with previous remarks. In-

deed, imposing the economic structure from the model (IR) into the model (MG)

Counterfactual (3) increases strongly the standard deviations of the nominal vari-

ables, which is inconsistent with the empirical regularities. By contrast, Counterfac-

tual (1) and Counterfactual (2) allow a dramatic reduction of the standard deviations

of ination and nominal interest rate. However, only Counterfactual (1), i.e. the ex-

ercise in which the interest rate rule from model (IR) is imposed in the model (MG),

leads to an increase in the standard deviation of money growth.

Table 4Counterfactuals: Standard Deviations

Specication Variable

Ination Interest rate Money growth

Mean 90% CI Mean 90% CI Mean 90% CI

(MG) 0.736 [0.551,0.954] 0.784 [0.627,0.979] 0.674 [0.555,0.830]

(1) 0.337 [0.257,0.420] 0.452 [0.385,0.528] 0.990 [0.895,1.099]

(2) 0.600 [0.392,0.961] 0.572 [0.434,0.763] 0.583 [0.450,0.848]

(3) 1.121 [0.763,1.659] 0.991 [0.649,1.493] 0.852 [0.579,1.287]

(4) 0.736 [0.586,0.915] 0.820 [0.672,1.014] 1.130 [0.981,1.310]

(5) 0.255 [0.196,0.322] 0.641 [0.518,0.788] 0.494 [0.461,0.528]

(6) 1.011 [0.692,1.397] 1.004 [0.718,1.372] 0.786 [0.550,1.098]

Note: For each 1000th parameter draw from the posterior distribution, 1000 samples with the same

length as the data are generated (after discarding 1000 initial observations). This table reports the

mean and the 90 percent condence interval (within square brackets).

18

The signicant eect of monetary policy to reproduce the two stylised facts led to

scrutinise its characteristics in order to evaluate their respective contributions. To

do that, we carry out the following set of counterfactual exercises:

Counterfactual (4): We analyze the role played by the type of policy instru-

ment (money growth, M

t

, versus interest rate, R

t

). To realise this exercise,

we target the standard deviation of ination calculated in the model (MG) and

deduce the coecients of an interest rate rule consistent with this value. We

then simulate as explained above.

Counterfactual (5): We study the relevance of the degree of reactivity, i.e.

the greater or lesser interest rate response to ination and to the growth rate

of output

_

,

y

_

. To do that, we target the standard deviation of ination

calculated in the model (IR) and deduce the coecients of a money growth rule

consistent with this value. We then simulate as explained above.

Counterfactual (6): We assess the relevance of the degree of gradualism, i.e.

a change in the value of the parameter

.

Figure 4 shows that the regressions obtained in Counterfactuals (4) and (6) do not

dier signicantly from the one obtained with the benchmark model. While the policy

instrument and the degree of gradualism seem to play a minor role, a monetary policy

shift towards a more aggressive antiinationary stance, as implemented from 1999 in

the euro area, leads to a breakdown of the quantity theory of money (Counterfactual

(5)). Turning to the analysis of standard deviations, we note that the stronger

reactivity by the monetary authority allows to explain the sharp drop in the volatility

of all the nominal variables. However, only a shift from a money growth rule to

an interest rate rule provides a marked increase in the volatility of money growth

(Counterfactual (5)).

The underlying mechanisms are the following. On the one hand, the breakdown

of the quantity theory of money when reacting suciently aggressively to incipient

inationary pressures is linked to the change in the variancecovariance matrix of

the macroeconomic variables. The quantity theory implies that any change in the

monetary aggregate induces a variation in the same direction and same magnitude

of price and of nominal interest rate. If price stability is the goal of central bank,

any increase in prices should result in a sharp contraction in the money supply. As

a consequence, both variances and covariances between nominal variables decrease.

But, implementing price stability or ination targeting while the underlying theory

establishes similar variations between prices and the monetary aggregate necessar-

ily induces a stronger fall of the covariances. This mechanical eect blurs the two

quantity propositions.

On the other hand, the interest rate as an instrument of monetary policy allows

understanding of the increase in the volatility of money growth. With an interest

elastic demand for real money balances, any shock that aects the path for expected

ination or the real interest rate causes money demand to shift. When the central

bank follows an interest rate rule, the money stock is endogenous and ination is

xed by the policy rule. Money absorbs the adjustment and the central bank can

19

accommodate this jump in the money stock almost instantaneously and with little

cost. It is the money stock, rather than the price level, that responds by shifting

downward to clear the money market. Hence, in an economy with stochastic ination

and an interest rate rule for monetary policy, the money growth rate is much more

volatile than the ination rate (Gavin et al., 2005). This explanation comes on top

of the possible composition eect of the monetary aggregates. Indeed, M2 comprises

two distinct categories (associated with portfolio motives and transaction purposes,

respectively) that are expected to move in opposite directions following a movement

in the short-term interest rate. If the remunerated category of M2 exercises a stronger

inuence than the most liquid category, an increase in the interest rate will result in

even higher M2 growth. We observe, however, that M1 volatility is greater than M2

volatility over the postEMU period (see Appendix A.1).

V. Conclusion and nal remarks

We have estimated a structural monetary model of the euro area business cycle to

examine the sources of both the empirical breakdown of the quantity theory of money

and the shift in the volatility of nominal variables over the period 19802007. Our

results suggest that a more antiinationary monetary policy and the transition from

a money growth to an interest rate rule explain these macroeconomic developments.

More generally, we shed light on the strong link between the quantity theory of money

and the conduct of monetary policy. Periods of improvements (resp. impairments)

in the conduct of monetary policy or in the functionning of the money market are

characterised by an empirical breakdown (resp. return) of the quantity theory of

money.

A very recent illustration is the return of the quantity of money concomitantly with

the implementation of nonstandard measures (see Appendix A3). But, contrary to

historical changes in the degree of responsiveness or instrument of the central bank,

unit slopes in scatter plots emerge because the usual interest rate channel is broken.

Since 2008, the relationship between the expected path of policy rates and market

rates broke down because the liquidity premia widened and became volatile. The

Lehman Brothers bankruptcy caused a freeze in the interbank market, forcing the

ECB to inject its funding capacity into it. The predominance of this liquidity channel

mainly aected banks and central bank balance sheets. After lowering its interest

rates drastically to a level close to zero, the ECB has eased monetary conditions

by increasing sharply the size of its balance sheet. However, given the atony of

the economy and the heightened uncertainty, banks prefer hoarding cash instead

of spending it. Liquidity has then circulated among nancial institutions but was

not transmitted to the real economy. Consequently, the huge increase in liquidity

did not trigger ination pressures. In addition, such a liquidity can be sterilized

by symmetrical operations of withdrawal. The ination rate remained practically

constant at the 2% level over the past four years. Moreover, the presence of excess

liquidity in the overnight market and the resulting recourse to the deposit facility

implied a fall in the euro interbank overnight money market rate. The evolution of the

interest rate has then become independent of ination. The traditional relationships

between ination, money growth and interest rate seem no longer valid.

20

With a larger sample available, the model and our approach would be used and

probably extended to examine more carefully the crisis period. For now, the recent

behavior of the monetary aggregates suggests that the quantity theory of money is

useful for detecting nancial stress, supporting McCallum and Nelson (2010).

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22

Appendix not Intended for Publication

A1. Robustness: Results for M1, M2 and M3 aggregates

Table A11Coecients of the regressions on ltered data (19802007)

on m R on m

PreEMU PostEMU PreEMU PostEMU

M1 0.63 0.08 0.57 0.25

M2 1.34 0.03 1.38 0.12

M3 1.16 0.10 1.08 0.01

Table A12Standard deviation of the growth of various monetary aggregates (19802007)

PreEMU PostEMU

PostEMU

PreEMU

M1 0.69 1.31 1.89

M2 0.52 0.60 1.17

M3 0.53 0.61 1.15

A2. Models details

A. Nonlinear equilibrium conditions

This section reports the rstorder conditions for the agents optimizing problems

and the other relationships that dene the equilibrium of the baseline model.

Eective capital:

K

t

= u

t

K

t1

Capital accumulation:

K

t

= (1 )

K

t1

+

i,t

_

1 S

_

I

t

I

t1

__

I

t

Marginal utility of consumption:

t

=

b,t

C

t

hC

t1

h

b,t+1

C

t+1

hC

t

Consumption Euler equation:

t

= R

t

E

t

_

t+1

P

t

P

t+1

_

23

Money demand equation:

t

=

b,t

m,t

1

z,t

_

M

t+s

P

t+s

_

+E

t

_

t+1

P

t

P

t+1

_

Investment equation:

1 = Q

t

i,t

_

1 S

_

I

t

I

t1

_

I

t

I

t1

S

_

I

t

I

t1

__

+E

t

_

t+1

t

Q

t+1

i,t+1

_

I

t+1

I

t

_

2

S

_

I

t+1

I

t

_

_

Tobins Q:

Q

t

= E

t

_

t+1

t

_

R

k

t+1

P

t+1

u

t+1

(u

t+1

) + (1 ) Q

t+1

__

Capital utilisation:

R

k

t

= P

t

(u

t

)

Production function:

Y

i,t

= K

i,t

[Z

t

N

i,t

]

1

Z

t

F

Labor demand:

W

t

= (1 ) Z

t

_

K

t

Z

t

N

t

_

MC

t

Capital renting:

R

k

t

=

_

K

t

Z

t

N

t

_

1

MC

t

Price setting:

E

t

s=0

(

p

)

s

t+s

t

Y

t,t+s

_

P

t

p

t,t+s

p,t+s

MC

t+s

= 0

Aggregate price index:

P

t

=

_

(1

p

) (P

t

)

1/(p,t1)

+

p

_

1

p

p

t1

P

t1

_

1/(p,t1)

_

(

p,t

1)

Wage setting:

E

t

s=0

(

w

)

s

t+s

N

t,t+s

_

W

t

P

t+s

w

t,t+s

b,t+s

w,t+s

_

N

t,t+s

_

t+s

_

= 0

24

Aggregate wage index:

W

t

=

_

(1

w

) (W

t

)

1/(w,t1)

+

w

_

1

p

w

t1

W

t1

_

1/(w,t1)

_

(w,t1)

Government spending:

G

t

=

_

1

1

g,t

_

Y

t

Monetary policy rule:

t

=

t1

_

_

_

Y

t

Y

t1

z

_

y

_

(1

r,t

Resource constraint:

Y

t

= C

t

+I

t

+G

t

+(u

t

)

K

t1

p,t

Y

t

=

_

u

t

K

t1

_

[Z

t

N

t

]

1

Z

t

F

B. Stationary equilibrium

To nd the steadystate, we express the model in stationary form. Thus, for the

nonstationary variables, let lowercase denote their value relative to the technology

process Z

t

:

y

t

Y

t

/Z

t

k

t

K

t

/Z

t

k

t

K

t

/Z

t

i

t

I

t

/Z

t

c

t

C

t

/Z

t

g

t

G

t

/Z

t

t

t

Z

t

w

t

W

t

/ (Z

t

P

t

) w

t

W

t

/ (Z

t

P

t

) m

t

M

t

/ (Z

t

P

t

)

where we note that the marginal utility of consumption

t

will shrink as the economy

grows, and we express the wage in real terms. Also, denote the real rental rate of

capital and real marginal cost by

r

k

t

R

k

t

/P

t

and mc

t

MC

t

/P

t

,

and the optimal relative price as

p

t

P

t

/P

t

.

Then we can rewrite the model in terms of stationary variables as follows.

Eective capital:

k

t

=

u

t

k

t1

z,t

25

Capital accumulation:

k

t

= (1 )

k

t1

z,t

+

i,t

_

1 S

_

I

t

I

t1

z,t

__

x

t

Marginal utility of consumption:

t

=

b,t

c

t

h

c

t1

z,t

E

t

_

_

h

b,t+1

z,t+1

_

c

t+1

h

c

t

z,t+1

_

_

_

Consumption Euler equation:

t

= R

t

E

t

_

t+1

z,t+1

t+1

_

Money demand equation:

t

=

b,t

m,t

m

t

+E

t

_

t+1

z,t+1

t+1

_

Investment equation:

1 = q

t

i,t

_

1 S

_

i

t

i

t1

z,t

_

i

t

i

t1

z,t

S

_

i

t

i

t1

z,t

__

+E

t

_

t+1

z,t+1

q

t+1

i,t+1

_

i

t+1

i

t

z,t+1

_

2

S

_

i

t+1

i

t

z,t+1

_

_

Tobins Q:

q

t

= E

t

_

t+1

z,t+1

_

r

k

t+1

u

t+1

(u

t+1

) + (1 ) Q

t+1

_

_

Capital utilisation:

r

k

t

=

(u

t

)

Production function:

y

i,t

= k

i,t

N

1

i,t

F

Labor demand:

w

t

= (1 )

_

k

t

N

t

_

mc

t

Capital renting:

r

k

t

=

_

k

t

N

t

_

1

mc

t

26

Price setting:

E

t

s=0

(

p

)

s

t+s

t

y

t,t+s

_

p

t

P

t

P

t+s

p

t,t+s

p,t+s

mc

t+s

_

= 0

Aggregate price index:

1 =

_

(1

p

) (p

t

)

1/(

p,t

1)

+

p

_

1

p

p

t1

1

t

_

1/(p,t1)

_

(p,t1)

Wage setting:

E

t

s=0

(

w

)

s

t+s

N

t,t+s

_

w

t

P

t

P

t+s

Z

t

Z

t+s

w

t,t+s

b,t+s

w,t+s

N

t,t+s

t+s

_

= 0

Aggregate wage index:

w

t

=

_

(1

w

) (w

t

)

1/(

w,t

1)

+

w

_

1

p

w

t1

w

t1

z,t

_

1/(w,t1)

_

(w,t1)

Government spending:

g

t

=

_

1

1

g,t

_

y

t

Monetary policy rule:

t

=

t1

_

_

_

z,t

y

t

z

y

t1

_

y

_

(1

r,t

Resource constraint:

y

t

= c

t

+x

t

+g

t

+(u

t

)

k

t1

/

z,t

p,t

y

t

=

_

u

t

k

t1

_

N

1

t

F

C. Steady state

We use the stationary version of the model to nd the steady state, and we let

variables without a time subscript denote steadystate values. First, the expression

for Tobins Q implies that the rental rate of capital is

r

k

=

z

(1 )

27

and the price-setting equation gives marginal cost as

mc =

1

p

.

The capital/labor ratio can then be retrieved using the capital renting equation:

k

N

=

_

mc

r

k

_

1/(1)

,

and the wage is given by the labor demand equation as

w = (1 ) mc

_

k

N

_

.

The production function gives the output/labor ratio as

y

N

=

_

k

N

_

F

N

,

and the xed cost F is set to obtain zero prots at the steady state, implying

F

N

=

_

k

N

_

w r

k

k

N

.

The output/labor ratio is then given by

y

N

= w +r

k

k

N

=

r

k

k

N

.

Finally, to determine the investment/output ratio, use the expressions for eective

capital and physical capital accumulation to get

i

k

=

_

1

1

z

_

z

,

implying that

i

y

=

i

k

k

N

N

y

=

_

1

1

z

_

z

r

k

.

Given the government spending/output ratio g/y, the consumption/output ratio

is then given by the resource constraint as

c

y

= 1

i

y

g

y

.

In addition, we have:

R =

z

.

28

D. Loglinearised version

We loglinearise the stationary model around the steady state. Let

t

denote the

log deviation of the variable

t

from its steadystate leve

l :

t

log

_

_

.

The log-linearised model is then given by the following system of equations for the

endogenous variables.

Eective capital:

k

t

+

z,t

= u

t

+

k

t1

Capital accumulation:

k

t

=

1

z

_

k

t1

z,t

_

+

_

1

1

z

_

(

t

+

i,t

)

Marginal utility of consumption:

t

=

h

z

(

z

h) (

z

h)

c

t1

2

z

+h

2

(

z

h) (

z

h)

c

t

+

h

z

(

z

h) (

z

h)

E

t

c

t+1

h

z

(

z

h) (

z

h)

z,t

+

h

z

(

z

h) (

z

h)

E

t

z,t+1

+

z

z

h

b,t

z

h

E

t

b,t+1

Consumption Euler equation:

t

= E

t

t+1

+

_

R

t

E

t

t+1

_

E

t

z,t+1

Money demand equation:

m

t

=

1

(

b,t

+

m,t

)

1

1

(R1)

R

t

Investment equation:

t

=

1

1 +

(

t1

z,t

) +

1 +

E

t

(

t+1

+

z,t+1

) +

1

2

z

(1 +)

( q

t

+

i,t

)

Tobins Q:

q

t

=

(1 )

z

E

t

q

t+1

+

_

1

(1 )

z

_

E

t

r

k

t+1

( r

t

E

t

t+1

)

29

Capital utilisation:

u

t

=

1

u

u

r

k

t

Production function:

y

t

=

Y +F

Y

_

k

t

+ (1 ) n

t

_

Labor demand:

w

t

= mc

t

+

k

t

n

t

Capital renting:

r

k

t

= mc

t

(1 )

k

t

+ (1 ) n

t

Phillips curve:

t

=

p

1 +

p

t1

+

1 +

p

E

t

t+1

+

(1

p

) (1

p

)

p

_

1 +

p

_ ( mc

t

+

p,t

)

Wage curve:

w

t

=

1

1 +

w

t1

+

1 +

E

t

w

t+1

(1

w

) (1

w

)

w

(1 +)

_

1 +

w

w

1

_ ( mrs

t

+

w,t

)

+

w

1 +

t1

1 +

w

1 +

t

+

1 +

E

t

t+1

1

1 +

z,t

+

1 +

E

t

z,t+1

Marginal rate of substitution:

mrs

t

= w

t

_

n

t

t

+

b,t

_

Government spending:

g

t

= y

t

+

1 g/y

g/y

g,t

Monetary policy rule:

t

=

t1

(1

)

_

t

+

y

( y

t

y

t1

+

z,t

)

+

r,t

Resource constraint:

y

t

=

c

y

c

t

+

i

y

t

+

g

y

g

t

+

r

k

k

y

u

t

30

A3. Scatter plots for the period 20082011

We extend our sample to include the years 2008 to 2011 and apply the low

frequency approach. Figure A31 displays the resulting scatters of points for the

current crisis period. While the slopes were at or even negative until 2007, we nd

that they revert positive over the past four years. In addition, one can even see a

concentration of points around the diagonal. Such ndings reveal a return of the

quantity theory of money.

0

2

4

6

8

0 2 4 6 8

Money growth

2010-2011

2008-2009

0

2

4

6

8

0 2 4 6 8

Money growth

2010-2011 2008-2009

Figure A31. Scatter plots of ltered money growth, ination and interest rate

31

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