Essays on Multilateral Divisia Monetary Aggregates for Euro Area

Abstract

Achieving the price stability in the economy is the primary objective of the European Central Bank as any other Central Bank. European Central Bank assign a very important role to monetary analysis in its objective of price stability. The role of a good measure of aggregate monetary services across countries in the euro area and the broader European Union is policy relevant. The Divisia monetary aggregation approach is consistent with index number theory and microeconomic aggregation theory, was developed by Barnett (2003, 2007). In the first chapter the multilateral Divisia monetary aggregates are constructed for the union of 24 Euro area countries. The monthly Divisia monetary aggregates for the euro area start from January 2003. In this chapter the currency in circulation, overnight deposits, deposits with agreed maturity up to 2 years and deposits redeemable at notice up to 3 months are aggregated. A comparison with the corresponding simple sum monetary aggregates shows that the multilateral Divisia monetary aggregates for the European Monetary Union and European Union is found to perform better and are good indicators of economic trends. Monetary aggregates have a special role under the "two pillar strategy" of the European Central Bank. Hence, the need for a theoretically consistent measure of monetary aggregates for the European Monetary Union is not trivial. The second chapter analyzes aggregation over monetary assets for the European Monetary Union, and studies the degree of substitutability of the monetary services. The question that is addressed is: “are simple sum aggregates theoretically consistent and an appropriate measure of monetary aggregates for European Monetary Union.” The monetary services of the union of eleven European Monetary Union countries is analyzed, which include Estonia, Finland, France, Germany, Ireland, Italy, Luxembourg, Malta, Netherlands, Slovakia, and Slovenia. The monetary services analyzed are transaction balances (it is a Divisia aggregation of currency in circulation and overnight deposits), deposits with agreed maturity up to 2 years and deposits redeemable at notice up to 3 months. The substitutability among these monetary assets is analyzed for the union of European Monetary Union within the framework of a representative consumer's utility function, using Barnett’s (1983) locally flexible functional form, the minflex Laurent Indirect utility function. The analysis of elasticities with respect to the asset’s user-cost prices shows that: (i) transaction balances and deposits with agreed maturity are income elastic and (ii) the monetary assets are not perfect substitutes for each other within the union of European Monetary Union. The necessary condition for the simple sum monetary aggregation is that the component assets are perfect substitutes. Results show that this necessary condition is not satisfied. Hence simple sum aggregation is not theoretically consistent and distorts measurement of the monetary aggregate. In the third chapter, the Divisia monetary aggregates for eleven European Monetary Union countries is used in estimation of nominal GDP of the same union of countries using Markov regime switching model.