Not all money is created equal: Divisia indices and the flow of funds

Please cite the paper as:
Merijn T. Knibbe, (2018), Not all money is created equal: Divisia indices and the flow of funds, World Economics Association (WEA) Conferences, No. 1 2018, Monetary Policy after the Global Crisis, 19th February to 20th April, 2018


Divisia indices are a clever proposal to enhance the informational content of the monetary aggregates by constructing a (neoclassical) theory consistent weighted aggregate of the amounts of different kinds of money (cash, different kinds of deposits, …). Ideally, the weights are, using interest rates, based upon the ‘medium of exchange’ content of a particular kind of money. This is not an entirely new idea. John Stuart Mill (1848) already noted that different kinds of money had different origins and uses and, hence, not the same kind of influence on the price level and the economy. Irving Fisher (1920) basically made the same point with his replacement of the ‘vulgar’ equation of exchange {MV=PT} by {MV+M’V’ = PT}, M and M’ denoting different kinds of money with different kinds of velocity. From a more recent and practical angle: the ECB will slowly phase out the 500,– euro bills as they are mainly used for hoarding and not for exchange. Divisia indices of a money-aggregate can be understood as a modern version of such ideas and efforts which takes the differences in velocity between different kinds of money into account and try to construct an estimate of money in which Fishers’ M and M’ get different weights. It basically tries to measure the amount of ‘exchange’ money, a concept which is more consistent with neoclassical micro than the well- known unweighted M1, M2 and M3 aggregates of money. This idea gets even more traction when we realize that M1 and M2 are actually not unweighted at all: the construction of these aggregates are based on an implicit weight of 1 for all kinds of money – without anyone arguing that this is the right weight! Though neoclassical, the idea behind Divisia money is however still at odds with neoclassical macro as a single ‘representative consumer’ doesn’t need money at all, not even to hoard.

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