Academic journal article Economic Inquiry

A New Empirically Weighted Monetary Aggregate for the United States

Academic journal article Economic Inquiry

A New Empirically Weighted Monetary Aggregate for the United States

Article excerpt

I. INTRODUCTION

This article uses an approach to long-run econometric modeling proposed by Pesaran et al. (2001; hereafter PSS) to develop an empirically weighted broad monetary aggregate for the United States and to demonstrate the advantages of this type of aggregate from a monetary policy perspective. In particular, we examine the ability of this type of approach to deal with periods of significant financial innovation and money demand instability.

A key requirement for monetary aggregates to provide a useful role in guiding monetary policy is that they should be stably related to the objectives of policy, such as inflation or nominal income growth. In this context, the United States has exhibited periodic evidence of significant money demand instability. Most notably, these have been Goldfeld's (1976) case of the "missing M1" in 1973/74 and the "missing M2" episode of the early 1990s (Feldstein and Stock, 1996). In both cases, the aggregate in question experienced a significant velocity increase and, as a consequence, previously established and apparently stable money demand relationships began to seriously overpredict the growth in these aggregates.

The missing M1 episode in 1973/74, together with subsequent evidence that M2 was more predictable than M1, led many economists to use M2 as an indicator of nominal activity. Hence, during the 1980s, M2 became the primary intermediate target of monetary policy. Furthermore, the primacy of M2 appeared to be well supported by the available empirical evidence. Feldstein and Stock (1994), for example, established that the rate of change of M2 was a statistically significant predictor of the rate of change of nominal gross domestic product (GDP) over the period 1959-92. Furthermore, M2 remained statistically significant when short-term interest rates were added to the relationship. Subsequent research, such as Miyao (1996) and Estrella and Mishkin (1997), however, cast doubt on the robustness of this result. Carlson et al. (2000, p. 34), for example, summarize the current situation by arguing that "the promising empirical conclusions of Feldstein and Stock (1994) that established predictive content for M2 in a vector error correction setting do not seem to find support in data that extend through the mid-1990s."

The key factor behind the breakdown in the M2 relation appears to have been the substitution away from time deposits and into mutual funds, particularly stock and bond mutual funds, in the low interest rate environment of the early 1990s. Although the definition of M2 has been expanded by the Federal Reserve in the past to include money market mutual funds (MMMFs) and money market deposit accounts (MMDAs), for example, a number of analysts (Duca, 1995; Darin and Hetzel, 1994; Orphanides et al. 1994) have advocated that M2 should be expanded further to include these stock and bond mutual funds (M2+). Significantly, these studies typically use the simple sum aggregation approach, in which all component assets are given equal and constant weights over time. This approach does not seem consistent, however, with the accumulating evidence of a significant shift in wealth-holders preferences sometime in the early 1990s. Carlson et al. (2000), for example, add to the empirical evidence that had accumulated during the 1990s by suggesting that the instability was associated with a permanent upward shift in M2 velocity between 1990 and 1994. Furthermore, they argue that "our results support the hypothesis that households permanently reallocated a portion of their wealth from time deposits to mutual funds" (p. 381). Clearly, simple sum aggregation is not able to take account of these changes in preferences. More significantly, however, simple sum aggregation cannot take account of any changes in the relationship between component assets and nominal income over time.

Although Carlson et al. (2000) do manage to reestablish a stable money demand relationship for the MZM (money at zero maturity) and M2M (M2 minus small time deposits) aggregates through the 1990s, this is only possible by specifically accounting for the financial innovation that occurred in the early 1990s. …

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