Monetary Policy Design in the European Union: Problems and Possibilities

AGUST][N ALONSO AND MIGUEL-ANGEL GALINDO*

ABSTRACT

The main goal of this paper is to estimate if the money supply and interest rate in the various European Union countries are exogenous or endogenous. This analysis turns is essential since, if both variables happened to be endogenous, the search for another variable to be used as a proximate target could be tried. Some authors have suggested that the exchange rate is likely to be that variable. (JEL P00)

INTRODUCTION

When, in the near future, file founding process of the European Union (EU) is concluded, it will mean that a certain degree of convergence among the member countries will be achieved. As a consequence, the different levels of economic activity present today will converge.

In effect, the EU integrates not only the rich and developed economies, also called the centre, but also the less rich or peripheral countries, with the intention of establishing a wider and stronger common market. The establishment of a real economic, political, as well as military union requires a certain degree of convergence among the members. This is the scope and meaning of what has been called the convergence conditions. As they are described in the Treatise of Maastricht, these conditions are a compulsory requirement to belong to the group of countries with the common monetary unit, the ECU.

Several authors, however have criticized the criteria of convergence, considering them to be more nominal than real. Leaving aside this polemical issue, the authors are interested in studying the way of establishing the future monetary policy through the European System of Central Banks (ESCB) before the adoption of the ECU.

If, in 1997, the new monetary unit is adopted, it will mean that half more than half of the countries integrated in the EU will have achieved the criteria of convergence, in which case the ECU will be a reality before the constitution of the ESCB. However, the ECU will most likely be imposed in 1999, and the monetary policy of the ESCB will have to be determined keeping in mind the instruments and intermediate objectives of monetary policy followed by the countries' members. Due to the lack of uniformity in their actions, this will be an obstacle for the common economic policy.

Closely related to this matter is the question regarding the endogenous or exogenous character of the intermediate monetary objectives. Their endogeneity or exogeneity will allow EU members to either accept or reject them for the design of the monetary policy. In order to perform this study, the authors first considered the endogeneity or exogeneity of the two more characteristic instruments of the monetary policy: the interest rate and the money supply. An econometric analysis will illustrate the conclusions.

*R.C.U. Maria Cristina, El Escorial and U. Complutense, Madrid.

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AUGUST 1995, VOL. 1, NO. 3 203

THE MONEY SUPPLY

Traditionally, money supply has been considered an exogenous variable. That is, the Central Bank can entirely control it. Despite the existence of autonomous factors of liquidity, the monetary authority could affect some other variable to neutralize the money not in accordance with its interests. Because of this possibility, the function of money supply is vertical. Moore [1988a] gives the name verticalists to these authorities. In such circumstances, only by the willingness of the Central Bank could it be possible to shift the function, affecting in this manner the rate of interest and the real sector of the economy.

Opposed to these authorities, the post-Keynesians defend the endogeneity of the monetary offer whenever the Central Bank will not generate more rigidities (tensions) than those strictly necessary (in the economy). Among post-Keynesians, two positions deserve to be mentioned [Pollin, 1991].

The accommodationists, who defend that the Central Bank, acting as the lender of last resort, will always grant money to private banks requesting it. According to this position, private banks looking for maximum profit will lend money as much as possible, going over the legal limits of the reserves that yield no benefits for them. However, in order to fulfill the regulations, private banks will resort to the Central Bank. The Central Bank could, of course, refuse their request, but this action could raise the rate of interest and, even more so, generate bankruptcies. To avoid these troubles, the Central Bank will lend the required money, endogeneizing in this way the money supply.

The structuralists, on the other hand, deny the possibility suggested by the accommodationists, since, in their opinion, the Central Bank can refuse to be the lender of last resort. They contend that the behaviors of institutions, especially the process of financial innovations, are the factors of endogenation of the monetary offer. Regardless of what is the cause for the endogenation of this variable, what is to be considered is the tact that if the Keynesian thesis was correct, the EU could not select the money supply as an intermediate objective. Rather, it should resort to the rate of interest as its operating instrument.

INTEREST RATES

As already mentioned, the existing literature on this topic is not unanimous on which factors affect interest rates. The authors will, therefore, underline the main approaches developed in this field for a better understanding of the complexity of this matter. One group of ideas which corresponds to Neoclassical theory, from its simplest point of view, explains interest rates as the result of confronting investment and saving [Harris, 1981]. In fact, changes in the money supply do not affect interest rates but only productivity and savings.

WickseU's approach is more complex. He distinguished between two types of interest rates: natural interest rate, determined between savings and investments, and market interest rate, fixed by lending institutions as a consequence of the loan supply and demand [1898, 1901]. The Swedish economist pointed out that the former is constantly subject to fluctuations for the changes in technology, employment supply, and alterations in wages [1898, p. 82]. Such interest rates must be equal to avoid strains in markets, excess of investment or savings, and alterations in prices.

Finally, the Fisher effect must be discussed, where the possible relationship between interest rate and inflation is established [Fisher, 1930, pp. 414-5]. When trying to test Gibson's paradox, Fisher remarked that if economic agents formulate forecasts, they could modify the monetary interest rate, following the same trend as prices. As a consequence, the real interest rate would remain constant. This leads to consideration of the problem of expectations behavior in the economic process: the way of their formation and impact in the monetary interest rate [Green, 1991, pp. 105-7].

204 INTERNATIONAL ADVANCES IN ECONOMIC RESEARCH

From this first group of ideas, it is suggested that interest rates are not affected by the money supply. Consequently, a real analysis, independent from a monetaristic one, becomes feasible [Rogers, 1989].

At a second stage, Keynes modified this setting. In fact, despite the evolution of his thinking on the matter, he finally established a link between the monetary and real sectors of the economy. In his early books, Tract on Monetary Reform, for instance, Keynes suggests that this variable faces some difficulties. Later, the Treatise on Money follows what WickseI1 had already explained. Finally, the General Theory breaks the trend established by those authors Keynes considered as classics, when he points out that monetary authorities and the market determine interest rate.

"But at a level above the rate which corresponds to full employment, the long-term market rate of interest will depend, not only on the current policy of the monetary authority, but also on market expectations concerning its future policy. The short-term rate of interest is easily controlled by the monetary authority..." [Keynes, 1936, pp. 202-4] In papers published after tile General Theory, Keynes expressed the same opinion as in his

Treatise: interest rates are determined in the short term by the monetary authorities primarily, instead of the liquidity-preference that he had introduced in the General Theory, while the interest rate was exogenous in the long term [Moore, 1988, pp. 127-8]. But he still considered the interest rate a monetary phenomenon.

"I consider that the difference between myself and the classicals lies in the fact that they regard the rate of interest as a nonmonetary phenomenon, so that an increase in the inducement to invest would rise the rate of interest irrespective of monetary policy." [Keynes, 1933, pp. 79-80] After Keynes, new contributions have appeared regarding the interest rate. The Neoclassical

Synthesis [Hicks, 1937] showed that interest rate is determined through money demand and supply. In this way, with an exogenous money supply controlled by monetary authorities, one can 'alter the interest rate when there is a constant demand by increasing or decreasing the money supply.

In the IS-LM framework, some economists, such as Meltzer [1951], have introduced wealth effects, affecting both savings and money demand. From this perspective, an increase in wealth may only influence prices but not the interest rate. The latter will be modified through open-market operations whenever it alters portfolio balance and, therefore, the margin to be maintained of money and bonds.l

On the other hand, from the monetarist perspective, these economists do not believe that changes in the money supply could significantly affect the interest rate, since an increase in money supply can be spent on a wide range of assets which are perfect substitutes fbr money. For monetarists, there is not such a well-defined interest rate, as in the case of Keynesians. Precisely, Friedman [1970] suggested that a change in money supply influences interest rates in one way and then conversely. This is the reason why there is not a reliable guide tbr monetary policy.

There is also the post-Keynesian perspective that tries to develop Keynes' thoughts by eliminating some ideas introduced by Keynesian economics. Different approaches can de detected. Some economists, Kaldor [1982] for example, think that the interest rate is exogenous, in such a way that monetary authorities can modify it through open-market operations. Besides, at a fixed interest rate, money supply is perfectly elastic. This approach is known as verticalistic [Moore, 1988a]. Others, however, think that the interest rate is endogenous, for it is determined either by an agreement among bankers willing to expand their business in face of a restrictive monetary policy [Randall Wray, 1990], or it is determined within an interactive process where market forces, through a process of financial innovation, play a significant role [Pollin, 1991, pp. 375-6].

As it has been shown, there is an important controversy on the nature of interest rates. On one hand, it should be clarified if there is a link between the real and monetary sectors, as well if interest rate can be considered endogenous or exogenous. There are still other explanations where the role of public deficit in determining interest rates is stressed [Miller and Russek, 1991], giving way to new possibilities of analysis.

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COINTEGRATION

The authors are interested in determining the endogenous or exogenous character of the money supply and the rate of interest. The monetary authority will have a greater control over that instrument which appears to be exogenous. To approach the topic, the theory of cointegration of variables is used. If the money supply and interest rate are cointegrated with other economic variables, they can be considered endogenous variables. If they are not cointegrated, then can be considered exogenous variables.

The main ideas of cointegration involve a vector of time series Yt, which is said to be cointegrated if each individual series is I(1) that is nonstationary with unit root. However, there is a linear combination of those series a 'y which is stationary or I(0) tbr some a = 0: a 'y 1(0). 2

Cointegration points out the fact that despite the many possible developments which can affect the variables, there is a long-run equilibrium relationship between the variables, represented by the linear combination a'y. In other words, cointegrated variables cannot wonder too far away from each other. In contrast, lack of cointegration suggests that those variables have no long-run relationship and, consequently, they can move arbitrarily far away from each other.

It has to be pointed out, however, that, at present, tests for cointegration are tests for stable linear relationships among variables. That is, failure to find cointegration does not necessarily mean that there is no stable long-run relationship among the variables. It only suggests that there is not a stable linear relationship among them. As an illustrationof the idea of cointegration, consider the I. Fisher's equation of exchange states:

M V = P Q , (1)

where: M is some measure of nominal money; V is velocity of money; P is an overall price index; and Q is real output. Taking natural logarithms, one produces:

l n M + l n V - l n P - l n Q : O. (2)

Written in this manner, the equation of exchange is an identity. The theory of the demand of money converts the identity into an equation, if the velocity of money is a function of other variables.

In the theory of money demand, V is unobservable. To make it testable, it has to be substituted by some proxy: V*. One then yields:

lnV* = lnV+ e , (3)

where e is random error associated with the proxy. In general, the proxy is a function of some economic variables other than income and prices that are considered to affect the demand for money. Substituting in (2) yields:

l n M + l n V * - l n P - l n Q : O . (4)

If the proxy is a good one, then the expected value of e should be zero, and e should be stationary, so that V* might deviate from its true value in the short run, but should converge to it in the long run. If that is the case, there is cointegration among these variables. If V* is not a good proxy, then there is not a stationary relationship among these variables, and cointegration will not exist among them. In the long run, the demand for money is :meaningless.

206 INTERNATIONAL ADVANCES IN ECONOMIC RESEARCH

From this point of view, Fisher's equation of exchange embodies the existence of a long-run relationship among money, prices, velocity, and output. That is, the existence of the cointegrating vector:

a ' : (1, 1 , - 1 , - 1 ) . (5)

This vector combines the four series into a univariate and stationary series e. To test this hypothesis, a test for cointegration can be performed by applying any conventional root test to e. To perform this unit root test, it is necessary to have knowledge of the cointegrating vector a. Most of the time, however, the cointegrating vector is unknown and has to be estimated using some linear combination of the variables.

Some examples of observed cointegration include an income and consumption theory by Davidson et al. [1978]. They found that both income and consumption are I(1), but in the long run, consumption tends to be an approximated fraction of income, the difference of logs is an stationary process. Kremers [1989] suggests that governments are politically forced to maintain their debt at approximately a constant multiple of GNP, in such a way that the difference log (debt)-log (GNP) results to be a stationary process, even though each single component is not. Other examples can be found in King et al. [1991] and Ogaki [1992], among others.

COINTEGRATION TEST IN SOME EU COUNTRIES

In order to test for the presence of cointegration, the procedure involves testing that the series involved are I(1) processes. Once that hypothesis is not rejected, construct the linear combination Zt = a'y. If a is a true cointegrating vector, the a 'y should be I(0). If a is not a cointegrating vector, then a 'y will be I(1). Thus, a test of the null hypothesis that Zt is I(1) is equivalent to a test of the null hypothesis thaty is not cointegrated. If Ho: Zt I(1) is rejected, the conclusion is that Zt = a 'y is stationary, or that Yt is cointegrated, with cointegrating vector a. The test of Zt I(1) can be performed with the tests of Dickey-Fuller or Phillips-Perron. A more specific procedure is provided by Johansen and Jnselius [ 1992].

The analysis in this paper postulates the following theoretical relations regarding money and interest rate:

Money = f (GNP, Public Balance )

Interest rate = f (GNP, CPI)

For a better understanding and easy interpretation of results, all data were transformed using logarithms. The log function is a monotonic function and a variance stabilizing transformation. It also allows for a reduction of scales in graphical representations and for the interpretation of regression coefficients as elasticities. If it happens that log (y t ) is a process I(1), then the rate of growth of the original series is stationary.

Another convenient reason for using logs is that when multiplying by 100 the logs of variables, and later taking first differences, changes in the variables are reported as percentile changes. For example, if (1-L) [100 In (yt)] = 1.0, then Yt is 1 percent greater than Yt-1.

One restriction to have present when using logarithms is that the data should be positive. This forces elimination of the public deficit, which usually has negative values, from the above relations. The testable relations are therefore:

AUGUST 1995, VOL. 1, NO. 3 207

M t : B1 +B2 G D P t + U t

I t : B I + B 2 G D P t + B 3 C P I t + v t ,

where: M T is monetary offer in the year t; I t is the interest rate in the year t; G D P t is the gross domestic product; C P I is the consumer price index; and ut and vt are random disturbances, with the usual conditions of independence

Data are considered for Germany, Ireland, Spain, and the United Kingdom. All data have been taken from the International Monetary Fund. The first consideration to point out is that all of the variables in the models have to be stationary. If that is not the case, one can face the problem of spurious regressions [Granger and Newbold, 1974; Phillips, 1986], unless the variables are cointegrated. If variables are not stationary and not cointegrated, it is necessary to transform the data before attempting the estimation of the model, to avoid spurious results. Some remedies for this situation include introducing lags in the model, for the explanatory variables as well as for the dependent variable. Taking the first differences for the variables or estimating the model with the adjustment of Cochrane-Orcutt can be solutions as well. Despite the fact that the first differences are the most applied solution for nonstationary series, it should be remarked that the solution is not always appropriate. For example, if the series are stationary but in the boundary of stationarity, the taking of first differences will generate a misspecified model. Also, if the series are nonstationary but are I(1) and cointegrated, differencing will produce a model misspecified.

RESULTS

The main results of the analysis are presented, considering the countries in alphabetical order. In all four countries, two different samples were considered: from 1960 to 1993 and from 1973 (when the European Monetary Systems was introduced) to 1993. The testing of the hypothesis is performed at the 5 percent level of significance, using the statistical tables in Hamilton [1994].

Germany Period 1960-93 The estimated regressions are:

I n M t = -2.6299 + 1.1249 l n G N P t + at

(t = -15.888) (t = 47.405) R 2 = 0.986 and ut = 0.90127 at - 1

(t=7.89)

l n l t = 1.071 + 1.4945 l n G N P t - 2.39 l n C P I t + at

(t = 1.458) (t = 2.56) (t = -2.1997) R2 = 0.3 and at = 0.4557 at - 1.

The null hypothesis of no cointegration, fails to be rejected. Period 1973-93

l n M t = -4.423 + 1.3648 l n G N P t + at

(t = - 12.848) (t = 29.407) R2 = 0.9785 and at = 0.7268 at - 1

(t = 3.935)

208 INTERNATIONAL ADVANCES IN ECONOMIC RESEARCH

l n l t = 0.2888 + 2 .4230 l n G N P t -3.837 l n C P l t + a t

(t = 0 .173) (t = 2 .105) (t = -1.9278) R2 = 0 .4696 and at = 0 .602 at - 1

( t = 3.397)

The hypothes is Ho: no cointegrat ion fails to be rejected.

Ireland Period 1960-93 The est imated regressions are:

l n M t = 0 .73937 + 0 .71925 l n G D p t + u t

(t = 11 .529) (t = 95.51) R2 = 0 .9966 and at = 0 .62199 at - 1

(t = 4.62)

l n l t = - 3 . 0 0 1 + 1.14567 l n G D p t - 1.31587 lnCPI t + a t

(t = -1.7) (t = 2 .392) (t = -1.945) R 2 = 0 559 and at = 0 .348 at - 1

(t = 2 .10)

Tile hypothesis Ho: no cointegra t ion is rejected. Period 1973-93 The estimates are:

l n M t = 0 .6659 + 0 .7270 l n G D P T + u t

(t = 11.529) (t = 38.4825) R 2 = 0 .9880 and at = 0.6293 at - 1 (34)

(t = 3 .4828)

l n l t = 4 .9323-0 .5405 l n G D P t + 0.6391 l n C P I t + a t

(t = 1.5831) (t = -0 .7163) (t = 0 .6473) R 2 = 0 05537, a very low coefficient o f determinat ion, and at = 0 .01545 at - 1

(t = 0 .06469)

The hypothesis Ho: no coin tegra t ionis rejected by the Z p o f Phi! l ips-Perron, but tails to be rejected

by Z t of the same authors.

S p a i n P e r i o d 1960-93 The estimates are:

I n M t = -0.8571 + 0 .9584 l n G D P t + a t

(t = -8.95) (t = 89.444) R2 = 0 .996 and at = 0 .8576 at - 1 (40)

(t = 9.18)

l n l t = 1.492-0.1533 l n G D P t + 0.609 l n C P l t + a t

(t = 1.743) (t = -0.82) (t = 2 . 3 8 )

AUGUST 1995, VOL. 1, NO. 3 209

R2 = 0 .846 and a t = 0 .4667 a t - 1 (43)

( t = 2 .5374)

The hypothesis Ho: no cointegrat ion fails to be rejected.

Period 1973-93

I n M t = -0 .69426 + 0 .9424 l n G D P t + a t (45) (t = -2 .344) (t = 31.63)

R 2 = 0 .984 and at = 0 .8824 a t - 1 (46)

(t = 8.26)

I n l t = 8.52-1.431 l n G D P t + 2.053 l n C P I t + a t (48)

(t = 3.078) (t = 0 .58286) (t = 2 .9529) R 2 = 0.663 and at = 0 .254 at - 1 (49)

(t = 1.049)

The hypothesis Ho: no cointegrat ion fails to be rejected.

United Kingdom Period 1960-93 The estimates are:

l n M t = -1 .98 + 1.0879 l n G D P t + ut

(t = -7.31) (t = -19.98) R2 = 0 .9258 and at = 0 .935 at - 1

(t = 12.963)

l n l t = 0.5843 + 0.8761 t n G D P t - 0.7907 l n C P I t + a t

(t = 1.44) (t = I. 195) (t = -0.855) R2 = 0 .5284 and at = 0 .7074 at - 1

(t = 4.096)

The hypothesis Ho: no cointegrat ion fails to be rejected. Period 1973-93

l n M t = -4.1 + 1.4543 l n G D P t + fit

(t = -6.44) (t = 12.87) R2 = 0 .8972 and at = 0 .512 a t - 1

(t = 7,2738)

l n l t = 2 .7376-0 .5134 I n G D P t + 0.6085 l n C P I t + a t

(t = 3.709) (t = -0.51) (t = 0 .49) Surpr is ingly , R2 = 0.17. The est imated regression o f residuals is a t = 0 .512 a t - 1

(t = 1.934)

The hypothesis Ho: no cointegrat ion fails to be rejected.

210 I N T E R N A T I O N A L A D V A N C E S IN E C O N O M I C R E S E A R C H

CONCLUSIONS

In this paper, the endogeneity or exogeneity of the money supply and interest rate have been analyzed from the point of view of the cointegration analysis, I f money supply or Interest rate was cointegrated with other macroeconomic variables, this could be interpreted as a sign o f endogeneity. If either was not cointegrated, it could be interpreted as a sign o f exogeneity.

From the analysis, there are indications that money supply and interest rate are not cointegrated with the relevant variables that were considered. The exception seems to be Ireland, which shows cointegration between the interest rate, GDP, and CPI. This paper, therefore, can favor neither money supply nor interest rate as the most convenient instrument for the monetary authority.

Cointegration is still a field o f open research. Much is still left to be said regarding the hypothesis proposed here. Some variables were left out, and the remaining countries o f the EU are still to be considered.

FOOTNOTES

I As Green [t991, p. 78] shows, Meltzer's conclusion depends on what is understood as wealth since, in the case of the debt-neutrality theory, the behavior of the monetary authority has no in/luence on the interest rate.

2 The nonstationarity of variables gives rise to some serious econometric problems. It can cause the possibility of spurious relationships. Furthermore, the parameter estimates from a regression model in which nonstationary variables are inconsistent, unless the variables are cointegrated.

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