DP5683 | Understanding the Link between Money Growth and Inflation in the Euro Area

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Announced in the autumn of 1998, the monetary policy strategy of the European Central Bank (ECB) quickly became controversial, arguably because the ECB provided neither an explicit representation of the inflation process nor an explanation for why it necessitated the adoption of a two-pillar framework. Several reduced-form empirical models that seek to do so have subsequently been presented in the literature. The hallmark of these models is the hypothesis that inflation can be decomposed into a 'trend', which is explained by a smoothed measure of past money growth, and a deviation from that trend, which is accounted for by the output gap. In this paper we survey this literature, discuss how it relates to the monetary transmission mechanism and extend the inflation equations by introducing cost-push shocks. We find that changes in import prices, oil prices and exchange rates are statistically significant in euro-area inflation equations but that they leave intact the earlier findings that money growth and the output gap matter.