On the Long-run Relationship Between Money, Output and Interest Rates: A Cointegration Analysis for West Germany

Abstract

The assumption of a stable long-run demand for money —i.e of a long-run relationship between real money balances, real output and an interest rate— is one of the main building blocks of modern macroeconomic theories. Moreover, it is a basic requirement for a policy of targeting a monetary aggregate as being practised —at least verbally— by the leading central banks since for than 15 years. However, beginning with Goldfeld’s (1976) “puzzle of missing money” in the United States hundreds of empirical studies have not provided a clear-cut support for the hypothesis of a stable demand for money function for various countries and different time periods since the mid 1970s⁽¹⁾. Evidence for Germany is mixed, too, although there is the presumption that instability of the German money demand — if there is any at all— is not as pronounced as in other countries⁽²⁾. Gaab and Seitz (1988) conclude that instability arises from the short-run adjustment processes, the long-run elasticities of income and the interest rate, respectively, showing a more stable behaviour over time.

“The concept of the long-run demand for money plays such a central role in macroeconomic theory that it is difficult to imagine living without it.”

Gordon (1984, p.406)

We are grateful for helpful comments of three anonymous referees.