Narrow money and the business cycle: Theoretical aspects and euro area evidence - Products Statistical working papers

This paper analyses the information content of M1 for euro area real GDP since the beginning of the 1980s. After a review of theoretical arguments on why real narrow money should help predict real GDP, in the empirical part we lay out evidence on the M1-GDP relation in the euro area, using results reported in the literature for the US as a comparison. We find that, unlike in the U.S., in the euro area M1 has better and more robust forecasting properties for real GDP than yield spreads. This property persists when one controls for a number of other influences. We also evaluate the out-of-sample forecasting performance of different classes of VAR models (Bayesian and classical; in levels and first differences; with or without error-correction mechanisms) comprising real M1, GDP and other indicators, using as benchmark a simple univariate model. Once the information from M1 is taken into account, what matters more for the forecast performance is the model class rather than the selection of additional indicators. However, most classes of VAR models are not capable of outperforming our simple benchmark. (The only exception are VARs in first differences).