Divisia Monetary Aggregates and Monetary Policy in a Small Open Economy

Abstract

The first chapter in my doctoral dissertation is co-authored with my advisor and it has been published in the Journal of Risk and Financial Management, August 2021. This paper applied the formula for user cost price of money and the recently developed credit-card-augmented Divisia monetary aggregates formula to construct monetary service indexes for Singapore. We produced state-of-the-art monetary service indexes from January 1991 to March 2021. We found that Divisia measures behave differently than simple sum measures in the period before the year 2000, when interest rates were high. Credit-card-augmented Divisia monetary services move closely with the conventional Divisia monetary aggregates, since the volume of credit card transactions in Singapore is relatively small compared with other monetary assets. The second chapter uses the constructed Divisia indexes and other data to examine different instruments of monetary policy and their relevance in predicting real economic activity in Singapore. I apply the Hamilton based filter to extract the cyclical component of each time series and compute the cyclical correlation of different targets of monetary policy including interest rate, money supply and exchange rate with output and inflation. I find that while exchange rate and all money measures show a weakly contemporaneous correlation with output and inflation, interest rate is not contemporaneously correlated to either output or inflation. Among different money measures, Divisia always shows a stronger correlation with both output and inflation than simple sum. Credit-card-augmented Divisia is the most informative indicator to predict output and price. To confirm the above statistical findings in a more rigorous framework, the last chapter in my dissertation revisits the issue of money measurement in the context of a small open economy using a recently developed micro founded DSGE model. I extend the New Keynesian model for a small open economy from the work of Faia and Monacelli in a similar manner to Belongia and Ireland by introducing private financial institutions, which create deposits as an imperfect substitute for government-issued currency. The banking sector allows the accommodation of multiple monetary assets like currency and interest-bearing-deposits. The central bank conducts its monetary policy via a simple interest rate rule. I explore the responses of different money measures including simple sum, monetary base, and Divisia quantity aggregate with respect to domestic and foreign shocks and compare these responses with those from a theoretical monetary aggregator. I find that Divisia tracks the movement of money most closely to the theoretical measure, followed by monetary base, while simple sum often does not match the correct trend. I analyze the impact of openness, which has an inverse relation with home-bias in consumption, on the volatility of macroeconomic variables. I find that as the small economy becomes more open, domestic inflation and nominal interest rate become more volatile while terms of trade and exchange rate become more stable. Among the different money measures, monetary base and Divisia follow the theoretical monetary aggregate to become less volatile as consumption becomes less home-biased, while simple sum, becomes more volatile.