Understanding the Link between Money Growth and Inflation in the Euro Area

Abstract

In preparation for the establishment of European Monetary Union in January 1999, the European Central Bank (ECB) decided to adopt a monetary policy strategy consisting of two main elements or ‘pillars’. The first of these was ‘a prominent role for money with a reference value for the growth of a monetary aggregate’ subsequently defined to be 4.5 per cent annual growth of M3, and the second ‘a broadly-based assessment of the outlook for future price developments’.¹ From the outset this two-pillar framework was controversial. One explanation for this might have been that the ECB provided neither an explicit representation of the inflation process nor a motivation for why it necessitated a two-pillar framework. Whatever the reasons, many observers misinterpreted the two pillars as combining monetary and inflation targeting, and criticised the framework for being inconsistent and lacking clarity.

We are grateful to Michael Sumner (our discussant) and conference participants for helpful comments and to Bjrn Fischer for data. The views expressed are solely our own and are not necessarily shared by the SNB or the BIS. Contact information: Katrin Assenmacher-Wesche: SNB, Brsenstrasse 15, Postfach 2800, CH-8022 Zürich, Switzerland, Tel +41446313824, email: Katrin.Assenmacher-Wesche@snb.ch; Stefan Gerlach: BIS, CH-4002 Basel, Switzerland, tel: +41612808523, email: Stefan. Gerlach@bis.org.