When Politics Meets Money: Geopolitical Risk and Money Demand in the US and Euro Area

ABSTRACT This paper investigates the impact of geopolitical risk on real money demand in the United States and the Euro Area using Divisia monetary aggregates. To account for the potential instability of money demand and the complex nature of geopolitical shocks, we employ a comprehensive empirical framework combining linear and non‐linear autoregressive distributed lag (ARDL) models with a Markov‐switching vector autoregression (MS‐VAR) approach. This framework enables us to capture not only short‐ and long‐run dynamics but also potential asymmetries, non‐linearities and regime‐dependent effects in the relationship between geopolitical risk and money demand. Our findings reveal that the effects of geopolitical risk on real money demand are both non‐linear and asymmetric, with important differences across regions. In the United States, positive geopolitical risk shocks increase money demand in the short run, reflecting heightened precautionary liquidity motives under conditions of uncertainty. However, this effect gradually reverses over time as economic agents rebalance their portfolios towards alternative safe‐haven assets. In contrast, geopolitical risk exerts a persistent negative effect on money demand in the Euro Area, suggesting heterogeneous liquidity preferences and varying risk perceptions across investors. This result may reflect the structural fragmentation and financial heterogeneity that continue to characterise the Euro Area. Furthermore, the Markov‐switching analysis highlights the state‐dependent nature of this relationship, showing that the impact of geopolitical risk on money demand is substantially stronger during periods of heightened volatility and uncertainty. These findings carry important implications for central banks, investors and policymakers by emphasising the role of geopolitical risk as a key determinant of liquidity conditions and monetary stability.