Modelling euro area money demand and forecasting inflation in a time-varying environment

In this paper, we present euro area money demand functions estimated for the sample period ranging from January 1994 to November 2010 with total and partial time-varying coefficients accounting for two structural changes. For this purpose, we make use of two different procedures viz. the Lee and Strazicich (2003) unit root test as well as the Bai and Perron (1998, 2003a, 2003b) methodology, which both enable us to determine unknown structural breaks endogenously from the data and we find evidence of two structural breaks in our series owing to the burst of the new economy bubble in 2001 and the global financial and economic crisis around 2007. Moreover, we illustrate that these breaks have affected the parameters of the money demand as well. Furthermore, we check if our demand for broad money with time-varying coefficients helps to improve p-star model based inflation forecasts and show that our forecasts outmatch those resulting from a fixed coefficient approach.