ABSTRACT

The development of the euro-area money stock M3 since the introduction of the common currency tends to nourish doubts about the usefulness of the second pillar in setting monetary policy. The ECB has fixed a reference value of 4.5 per cent for M3 growth. Provided real GDP is near its potential level, the reference value equals the rate of increase in M3 that the ECB considers to be consistent with its objective of keeping HICP inflation slightly below 2 per cent. As indicated by Figure 5.1, M3 growth since 2001 has continuously exceeded its reference value in the past three years by an ever-increasing margin. Despite the excessive growth in M3 during much of the period 2001-2007, inflation has hovered about 2 per cent since 2002, contrary to what one would expect if the deviations from the reference value were to contain useful policy information. Despite the difficulties of extracting policy signals from aggregate M3, the ECB continues to emphasise the usefulness of its second pillar. It expends considerable efforts in explaining the analysis underlying its second pillar to the public. Nevertheless, I do not find the ECB’s defence of its second pillar entirely convincing. Although the ECB’s analysis leaves something to be desired, I do not wish to go as far as Woodford and Svensson and to reject money as a policy indicator. Rather, I sketch an alternative procedure the ECB could employ for extracting policy signals from the monetary aggregates. The procedure presented in this chapter could usefully supplement the ECB’s arsenal of analytical tools, as it is immune to some of the critical arguments raised against the ECB’s second-pillar analysis.