An analysis of the time-varying behavior of the equilibrium velocity of money in the euro area

Recent developments in inflation and M3 velocity in the euro area have raised serious doubts about the reliability of M3 growth as a pillar of the ECB's monetary policy strategy. We develop a very flexible and comprehensive state-space framework for modeling the velocity of circulation. Our specification allows for the estimation of different autoregressive alternatives and includes control instruments, whose coefficients can be set up either common or idiosyncratic. This is particularly useful to detect asymmetries in the reaction among countries to common shocks. Our findings first suggest that the downward trend of M3 velocity is mainly explained by the evolution of permanent income, proxied by the trend component of per capita income, and also exhibits a high persistence. A second relevant result is the asymmetric impact of business cycle fluctuations in the evolution of the unobserved state that drives the varying parameters, causing the instability of velocity. Third, the estimated model emphasizes the role of changes in uncertainty and risk premia with heterogeneous and asymmetric effects for the different member countries of the euro area. Hence, although monetary aggregates can be used as a nominal anchor, it is essential, especially for the case of peripheral EMU countries, to complement these measures with other policies, not only unconventional monetary policies, but also the use of fiscal and structural initiatives.