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.