Monetary Aggregate
A monetary aggregate is a measure of the quantity of money in an economy, defined by the set of assets included. Different aggregates, from narrow measures including only currency and demand deposits to broad measures including various liquid assets, provide alternative views of monetary conditions and are used as indicators for policy and analysis.
Definitions and Components
Narrow aggregates, often denoted M1, typically include currency in circulation and demand deposits, sometimes with other highly liquid deposits. Broader aggregates, such as M2 and M3, add savings deposits, time deposits, money market instruments, and other liquid assets. The precise definitions vary across countries and change over time as financial innovation alters the liquidity of various instruments.
The choice of aggregate depends on the purpose. Narrow measures are closely related to transactions and are useful for analysing the medium of exchange function. Broad measures capture the store of value function and are more closely related to saving and portfolio behaviour.
The Quantity Theory and Its Limitations
The quantity theory of money relates the money supply to the price level through the equation of exchange, in which the money supply multiplied by velocity equals the price level multiplied by real output. If velocity and output are stable, changes in the money supply translate into proportional changes in prices.
The relationship has proved unstable in practice, particularly in recent decades. Financial innovation, changes in payment technology, and shifts in the demand for money have altered velocity, weakening the link between monetary aggregates and nominal income. This instability contributed to the decline of monetary targeting in favour of inflation targeting.
Monetary Aggregates as Policy Indicators
Central banks monitor monetary aggregates as indicators of monetary conditions and of inflationary pressure. Rapid growth of broad money may signal incipient inflation, while weak growth may signal insufficient demand. However, the information content of aggregates is limited by the instability of velocity and by the difficulty of interpreting changes in the composition of money.
Some central banks use monetary aggregates as one of several indicators in their policy frameworks, while others rely primarily on interest rates and inflation forecasts. The role of aggregates varies with the structure of the financial system and the effectiveness of alternative instruments.
Measurement Issues
Measuring monetary aggregates requires data on the liabilities of financial institutions and on the instruments that serve monetary functions. The boundary between monetary and non-monetary assets is not sharp, and the treatment of instruments such as money market funds, repurchase agreements, and foreign currency deposits affects the measurement.
Changes in the financial system, including the growth of shadow banking, complicate the measurement and interpretation of aggregates. The analysis of monetary conditions therefore often considers a range of indicators, including credit aggregates, in addition to traditional monetary measures.
Targets and Intermediate Variables
Monetary aggregates have been used as intermediate targets of monetary policy, with the central bank setting a target for the growth of a chosen aggregate and adjusting instruments to achieve it. This approach, known as monetary targeting, was adopted by several central banks in the 1970s and 1980s as a way to control inflation.
The approach requires a stable relationship between the aggregate and the ultimate objective, typically inflation. The instability of velocity and the changing nature of money undermined this relationship, and the approach was largely abandoned in favour of inflation targeting.
Velocity and the Demand for Money
The demand for money depends on income, interest rates, and the opportunity cost of holding money. The velocity of circulation, the ratio of nominal income to the money stock, reflects the frequency with which money is used in transactions and the portfolio decisions of households and firms.
The stability of velocity is crucial for the usefulness of monetary aggregates as indicators. Where velocity is stable and predictable, changes in the aggregate translate into predictable changes in nominal income. Where velocity is unstable, the relationship breaks down, and the information content of the aggregate is reduced.
Financial Innovation
Financial innovation changes the nature of money and the boundaries between monetary and non-monetary assets. The development of interest-bearing transactions accounts, money market funds, and electronic payments has altered the demand for money and the composition of aggregates.
Innovation complicates the measurement and interpretation of monetary aggregates, because assets that were once non-monetary may become monetary, and vice versa. The redefinition of aggregates and the breaks in the data make historical comparisons difficult.
Credit Aggregates
In recognition of the limitations of monetary aggregates, analysts and central banks also monitor credit aggregates, which measure the outstanding stock of borrowing in the economy. Credit aggregates capture the financing of spending and are closely linked to financial conditions and to the risk of instability.
The analysis of credit, including its growth, composition, and distribution, provides information complementary to that from monetary aggregates. Together, they inform the assessment of monetary and financial conditions and the design of policy responses to developments in the economy.