Abstract

Liquidity in the Economy Overall as Policy Reference in Money Supply

This contribution attempts to define “liquidity in the economy overall” in a way that allows it to serve as policy reference in money supply. This consideration starts from the assumption that “liquidity” represents a phenomenon that escapes direct observation and can only be measured indirectly. This contribution employs a MIMIC model for describing the relationship between latent and perceptible quantities of liquidity. The model parameters have been estimated on the basis of quarterly data for Germany for the period from 1974:1 to 1995:4. Empirical findings suggest the existence of a latent variable for “liquidity in the economy overall” indicating that this variable possesses better prognosticating properties than money supply M3 for the rate of inflation and the real rate of growth. This suggests the conclusion that it would be preferable for government and the European Central Bank of the future to give priority to a multivariate liquidity concept as policy reference in money supply.