Monetary Asset Substitution in the Euro Area

We study the relation between holdings of monetary assets and government securities in the Euro area. We estimate time-varying elasticities of substitution between monetary assets using the semi-nonparametric method of Gallant (1981). The empirical elasticities are then tested for structural breaks using the framework of Bai and Perron (1998). Since our sample starts from January 2000, we discuss explicitly the implications of the recent financial turmoil of 2007. The estimated elasticities are consistent with the assumption of imperfect substitution between monetary assets. Our results suggest that three main types of episodes affected the stability in the dynamics of monetary assets, including the 2001-2003 episode of heightened risk aversion, the outbreak of the recent financial crisis, and the Lehman bankruptcy.