CEIC News@lert: Divisia Monetary Aggregates and Economic Activity

August 7, 2014 INTRODUCTION The Shortcomings of Traditional Simple-Sum Monetary Aggregates As coincidental and sometimes leading indicators of economic activity and prices, monetary aggregates are expected to shed light on the transactions motive for holding money, i.e. the need for liquidity which can translate into nominal spending in the economy. Traditionally, a simple sum of all components of the monetary holdings, from highly liquid notes and coins in circulation to illiquid assets such as savings accounts, has been reported and analysed. Because of the very diverse nature of these monetary assets, however, the simple aggregates cannot account for the different motives economic agents have for holding these assets. Thus, the dynamics of simple summation of money supply sometimes provide dubious signals for spending and price developments. Why Divisia Money? Divisia Monetary Aggregates (Divisia money) overcome these shortcomings by weighting the different components of money supply according to their usefulness for transaction purposes. Arguably, these weighted aggregates exhibit a more robust relationship with current and future nominal spending and inflation and thus may prove to be a more reliable tool for macroeconomic analysis and monetary policy formulation. HIGHLIGHTS The Rationale Behind the Divisia Monetary Aggregates According to orthodox economic theory, money serves three main purposes: medium of exchange, unit of account and store of value. As a medium of exchange, money is used to facilitate transactions and thus feeds into nominal spending and prices. Because some assets are more liquid than others, in the context of the medium-of-exchange function of money, the various components of money supply have a different “degree of moneyness”. By giving less weight to those assets held by economic agents for savings purposes, Divisia money provides a better measure of the need for liquidity in the economy. Data suggest that differences between the growth rates of simple-sum aggregates and Divisia money are often significant. For instance, the growth rates of the two monetary aggregates in Poland have decoupled somewhat since 2008. While the M3 simple-sum aggregate continued to grow until the first quarter of 2009, the M3 Divisia measure started to decline as early as the beginning of the third quarter of 2008. It might be argued that the impact of the already unfolding global financial crisis on the Polish economy was reflected in the decline of Divisia earlier than in the simple-sum monetary holdings. Calculation of Divisia Money Index The calculation of Divisia monetary aggregates hinges on two broad assumptions:
  • A differentiation can be made between money holdings with different levels of liquidity;
  • Less liquid assets pay higher interest rates, so as to induce economic agents to hold them.
Thus at any given time, economic agents are faced with a portfolio allocation choice based on the premise that utility is derived from holding assets which are more easily convertible into other types of assets (they are more liquid, e.g. notes, coins, demand deposits, etc.). To account for the differing degree of liquidity associated with the various types of monetary assets, a broad approach is to calculate the difference between the interest paid on the respective type of asset and the interest paid on an asset which has no transaction value, i.e. it is used as a pure store of value. The higher the interest rate differential, the higher the user cost of holding the asset (the foregone interest from not holding less liquid assets, such as government bonds), then the higher the weight it has in the calculation of the Divisia money aggregate. As an illustration, the Bank of England publishes sectoral breakdowns of Divisia money. The table (below) shows the household deposits used in the calculation of the Divisia money, as well as the seasonally-unadjusted interest rate on the respective component where applicable. The Divisia monetary aggregate is commonly reported in an index form. For a brief methodological note on the computation of the index, please see the box below. The Divisia Money Index The index reported by the Bank of England and the National Bank of Poland is of the type: Where D stands for Divisia money index, S is the two-period moving average of the weighted shares of the assets calculated via the user cost of the assets, M stands for the money holdings of the respective assets, ∆ is the first difference operator, and ln stands for the natural logarithm. The user cost of the respective asset is calculated as the difference between the interest earned on an illiquid asset (R) and the interest on the component asset (r). The choice of a benchmark asset is highly arbitrary and both the Bank of England and the National Bank of Poland have adopted a so-called ‘envelope approach’: the benchmark asset for any given period is the component of money supply with the highest return. APPLICATION According to some of the research on this topic, Divisia money holdings may provide an early indication of imminent nominal spending. For instance, the Divisia money held by UK households exhibits a clear-cut relation to household consumption in most instances. The short-run relationship between Divisia and spending is inverse because spending is financed by drawing down on money balances. In the long run, however, research has shown that there exists a strong positive relation between the two because increased money holdings allow economic agents to increase spending. A similar long-run relation exists between Divisia money held by the private non-financial corporations and aggregate investment, although the short-run variations of investment are more difficult to quantify. Commonly, the Divisia aggregates and spending and investment are modelled in terms of their deviations from the long-run trends. However, even a simple comparison of the growth rates as in the charts above suggests that Divisia money may, under certain conditions, provide an early indication of turning points in economic activity. CONCLUSION Although Divisia money measures have now been calculated and analyzed by a vast number of central banks, historical time-series are currently provided only by a few - the Bank of England and National Bank of Poland among them. However, the growing awareness of the shortcomings of traditional simple-sum aggregates compared to Divisia money is expected to result in an increased number of central banks commencing regular reporting of Divisia money indices. This, in turn, means that Divisia money will play an ever-more-important role in the debate of defining and analysing the monetary policy framework, and in the decision-making process of all users of macroeconomic data. Discuss this post and many other topics in our LinkedIn Group (you must be a LinkedIn member to participate). Request a Free Trial Subscription. Back to Blog
7th August 2014 CEIC News@lert: Divisia Monetary Aggregates and Economic Activity