Monetary integration, money-demand stability, and the role of monetary overhang in forecasting inflation in CEE countries

Abstract

This paper tests the stability of the money-demand function in selected Central and Eastern European countries and investigates the extent to which money helps predict inflation. We first show that long-run money demand is better described with an open-economy model, which considers a currency-substitution effect, rather than the closed-economy model used in several previous studies. From the estimated models, we derive two measures of monetary overhang. Then we compare the ability of open-economy model and closed-economy model based measures of monetary overhang to predict inflation in the CEE countries (i.e., the Czech Republic, Hungary, and Poland). Whereas we cannot detect a significant difference in forecast accuracy between the two competing models, we show that the open-economy model based forecast model that reveals a stable long-run money demand encompasses the closed-economy model based version.