EURO INCREASINGLY USED AS A RESERVE CURRENCY IN INTERNATIONAL
MARKETS
The euro is increasingly being used as a trusted reserve currency in international
markets, according to research by Matteo Barigozzi and Antonio Conti, presented at
the Royal Economic Society’s 2011 annual conference.
The study looks at the growth in demand for the euro since its introduction in 1999. It
notes that the European Central Bank had targeted an annual growth rate for the
number of euros in circulation of 4.5% – but in the decade to 2008, the average growth
rate was more than 7%.
The researchers look at several possible explanations, including the rise in house
prices and stock prices across Europe. They find that the main reason for this increase
has been growth in demand from international markets wanting to keep the euro as a
reserve currency as it is less volatile than other currencies.
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Euro area money demand is stable, once you account for international financial
markets in the set of motives for holding money, according to this study.
In September 1998, the European Central Bank (ECB) Governing Council revealed its
two-pillar monetary policy strategy, assigning a prominent role to monetary aggregates
in the achievement of its statutory objective of price stability.
In practice, jointly with the adoption the economic analysis pillar, which focuses on real
variables such as oil price, wages and unemployment to predict inflation, the ECB
decided to monitor a reference value for the growth rate of M3, establishing that an
annual increase of 4.5% should be consistent with an inflation target close to or below
2%.
It is difficult to reconcile this view with the crude numbers observed from that moment:
while the average yearly inflation rate has amounted to 1.99%, exactly the ECB target,
the average growth rate in the nominal monetary aggregate of reference for the period
1999-2008 has been around 7.16%, much above the reference value of 4.5%.
This means that despite the remarkable growth of liquidity, the ECB has been
successful in constantly hitting its target.
Hence, at some point, one may think that the linkage between inflation and money
growth is weakened at the very best: for this to be true, signs of instability should be
detected in money demand, which relates the demand for real balances to income,
inflation and interest rates.
What happened? The increase in liquidity was seen in asset prices and particularly
house price inflation instead of goods market inflation. Indeed, over the same period in
which inflation has been under control, house prices increased at a yearly rate of
5.43%.
Research has proposed different explanations for the apparent instability of money
demand, but the main focus has concerned financial and labour markets variables, as
proxies for the muted risk attitude of the economic agents.
Examining a battery of the most recent and influential papers analysing these new
motives for holding money, by means of a statistical state-of-the-art analysis of
competing models of euro area money demand, this study finds insufficient accounting
for developments in housing markets to observe a stable relation for money holdings.
In particular, international financial markets emerge as source of stability of euro area
money demand – that is, you have to adopt a portfolio approach to money demand in
which savers/investors choose between home and foreign assets. This highlights a role
as a reserve currency for the euro in the new globalised economy.
Second, the study re-establishes the relevance of money demand for policy analysis.
Furthermore, the weakened co-movement between money growth and inflation joint to
the higher correlation between money and domestic and foreign price earnings ratios
suggests to shift the focus of the monetary pillar of the ECB from price stability to
financial stability.
Euro area money demand is stable, but neither house prices nor stock prices volatility
nor unemployment and labour markets variables explain its anomalous path from 1999
to 2008. Rather, international financial markets are the key determinant.
ENDS
‘On the Sources of Euro Area Money Demand Stability: A Time-varying Cointegration
Analysis’ by Matteo Barigozzi and Antonio Conti
Dr Matteo Barigozzi is a lecturer at LSE; Antonio Conti is a researcher at the Bank of
Italy
Contact:
Antonio Conti
Mobile: +39 349 2628144
Email: antoniomaria.conti@bancaditalia.it