ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Monetary Aggregates

A Consistent Message by an Inconsistent Messenger

An exploration of the information content within money confirms that despite the theoretical inconsistence inherent within a simple sum monetary aggregate, money supply (M3) has been a consistent leading indicator of the general slowdown in economic activities in India since March 2010. The paper also establishes an exogenous influence of the central bank balance sheet over M3 through a statistically stable money multiplier, a long-term stable relationship, and bidirectional Granger causality between M3 and reserve money. However, the monetary policy measures of the central bank that determine reserve money themselves take a cue from economy-wide factors, as presented in a multivariate forecast model for reserve money.

The views expressed are those of the authors and do not necessarily represent the views of the Reserve Bank of India. The usual disclaimers apply.

The new consensus macroeconomics model or new neo-classical synthesis seems to have provided the grounds for theoretical convergence over monetary policy conduct in the viewpoint of central bankers and macroeconomists off late. Correspondingly, there has been a steady de-emphasis on the role of quantitative monetary aggregates in framing monetary policy (Rangarajan and Nachane 2021). The questions raised over the money multiplier mediated relationship between money supply and reserve money (also called monetary base or high-powered money) and debates over volatility in money velocity as well as over the endogeneity of money supply contributed to the growing disenchantment with the money demand function owing to its stability concerns (Woodford 1998). Apart from these more recently debated macroeconomic aspects, in the past too, the critics of simple sum monetary aggregates advocated the use of microeconomic foundations, such as aggregation and index number theories, in constructing a superlative class of quantitative indices (Diewert 1976). In his seminal work in the 1980s, William A Barnett opined replacing inconsistent simple sum monetary aggregates with monetary aggregates constructed using the concept of divisia quantity indices. The “Barnett Critique” (Chrystal and Macdonald 1994) highlights the internal inconsistency between the simple sum monetary aggregation (where components are perfect substitutes of each other) and the economic theory used to build models in which such aggregates are included.

Nevertheless, since the advent of the inglorious global financial crisis (GFC) in 2007–08 and the more recent COVID-19 pandemic-led disruptions, monetary policy stakeholders have been compelled to undertake atypical corrective measures. With an unprecedented fall in real output amid interest rates nearing a zero lower bound (ZLB) in quite a few countries, including the United States (US), unconventional (or a return to old-school quantity-based conventional) measures have been adopted targeting not only the cost but also the availability of finance to various sectors (Bernanke 2009). Thus, central bank balance sheets are witnessing a massive expansion due to quantitative easing measures globally. Central banks can create money via balance sheet expansion on the back of direct asset purchases/quantitative lending, which increases reserve money. In doing so, they attempt to influence the supply of money in the system so as to tide over shocks on the real side, due to either a slack in demand or impairment in bank lending. Thus, the role of reserve money in driving money supply through the money multiplier framework is back in the limelight, notwithstanding that money is endogenous, thus emphasising the liquidity channel of monetary policy (Chakraborty et al 2020). All this comes with an implicit understanding that the woes of the real economy need monetary stimulus.

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Updated On : 3rd Apr, 2023
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