Expected Money Growth, Markov Trends and theInstability of Money Demand in the Euro Area

This paper analyzes the recently documented instability of money demand in theeuro area in the framework of a Markov switching trend model. First, we consider astandard flexible price model with stable money demand, rational expectations, andan exogenous income-money ratio which follows a Markov trend. This framework,which implies an influence of expected future money on prices, leads to a cointegrating relationship between (log) prices and the (log of the) money-income ratiowith a switching intercept term. Of course, this likely leads to a rejection of cointegration by standard tests and to the erroneous conclusion of an unstable moneydemand. Second, a more general model allowing for endogeneity and more generaldynamics is estimated with Bayesian methods for euro area data from 1975-2003.This exercise provides support for our model and a stable demand for M3 in theeuro area.