JOURNAL OF APPLIED ECONOMETRICS J. Appl. Econ. 16: 341–358 (2001) DOI: 10.1002/jae.603 EUROPEAN INTEGRATION AND MONETARY TRANSMISSION MECHANISMS: THE CASE OF ITALY KATARINA JUSELIUS* Institute of Economics, University of Copenhagen, Studiestraede 6, DK-1455, Copenhagen K, Denmark SUMMARY The focus in this paper is on the monetary transmission mechanism in Italy and how it has changed with the increased independence of the Italian Central Bank and the increasingly fixed exchange rates of the ERM. The sample period 1974–1994 is divided into two parts approximately corresponding to the different systems. Based on a VAR model for money, income, prices, and interest rates the cointegration properties of the data in nominal and real terms are analysed. Long-run price homogeneity is empirically rejected and the economic and econometric consequences for a real money analysis are described. Altogether we find little evidence that the use of M2 and the short interest rate as intermediate targets has effectively controlled price inflation in this period. Copyright  2001 John Wiley & Sons, Ltd. 1. INTRODUCTION This paper investigates changes in the Italian monetary transmission mechanism associated with the increased independence of Banca d’Italia and the increased economic integration within Europe. The Italian money market has experienced several fundamental changes in the last three decades associated with the instruments used by the central bank, the relationship between the central bank and the government, and debt management. Not surprisingly, previous empirical studies of Italian money demand have demonstrated substantial difficulties in finding a stable relation over the present period (Bagliano and Favero, 1992; Angelini et al., 1994). Here we extend the conventional money-demand analysis with a few more steady-state relations important for the domestic monetary transmission mechanism. The adjustment dynamics is estimated as a system of (equilibrium) error correction models originally suggested by Sargan (1964) and further developed by his students (see, for example, Hendry, 1993). After the breakdown of the Bretton Woods system the M2 liquidity ratio grew rapidly in 1971–4 in spite of high inflation and almost constant opportunity costs of holding money relative to bonds. During the transition period to the EMS (European Monetary System) the liquidity ratio declined drastically in 1979–82. At the end of the sample when Italy struggled to meet the entrance criteria of the EMU (European Monetary Union) the liquidity ratio declined again in spite of the low opportunity costs of holding money. The graphs of the inverse M2 velocity (the liquidity ratio) and its main determinants in Figure A1 in the Appendix 1 illustrate the volatility of the analysed period 1974–98. Ł Correspondence to: Katarina Juselius, Institute of Economics, University of Copenhagen, Studiestraede 6, DK-1455, Copenhagen K, Denmark. E-mail: katarina.juselius@econ.ku.dk Contract/grant sponsor: Danish Social Sciences Research Council. 1 Most graphs in this paper are produced by GiveWin, (Doornik and Hendry, 1998). Copyright  2001 John Wiley & Sons, Ltd. Received 16 December 1998 Revised 19 February 2001