Abstract
The issue of whether or not money affects real economic activity (money neutrality) has attracted significant empirical attention over the last five decades. If money is neutral even in the short-run, then monetary policy is ineffective and its role limited. If money matters, it will be able to forecast real economic activity. In this study, we test the traditional simple sum monetary aggregates that are commonly used by central banks all over the world and also the theoretically correct Divisia monetary aggregates proposed by the Barnett Critique (Chrystal and MacDonald, 1994; Belongia and Ireland, 2014), both in three levels of aggregation: M1, M2, and M3. We use them to directionally forecast the Eurocoin index: A monthly index that measures the growth rate of the euro area GDP. The data span from January 2001 to June 2018. The forecasting methodology we employ is support vector machines (SVM) from the area of machine learning. The empirical results show that: (a) The Divisia monetary aggregates outperform the simple sum ones and (b) both monetary aggregates can directionally forecast the Eurocoin index reaching the highest accuracy of 82.05% providing evidence against money neutrality even in the short term.
Highlights
The main monetary policy approach since the 1980s focuses on short-term interest rates; the role of monetary aggregates is reduced in the implementation of monetary policy
Divisia monetary aggregates outperform the simple sum ones and (b) both monetary aggregates can directionally forecast the Eurocoin index reaching the highest accuracy of 82.05% providing evidence against money neutrality even in the short term
Reference [17] shows that forecasts of USA real GDP from a four-variable vector autoregression are most accurate when a Divisia aggregate is included rather than a simple sum aggregate. The innovations of this empirical work are: (a) We compare the forecasting ability of the simple sum and the Divisia monetary aggregates on the economic activity using the Eurocoin index (The Eurocoin is computed by the Bank of Italy and the CEPR.): An index coincident with the euro area business cycle that includes information on the underlying growth rate of the euro area GDP and it is published monthly in contrast to the GDP that is available only quarterly; (b) we depart from the traditional econometrics area and employ the support vector machines (SVM) methodology for classification from the machine learning toolbox; and (c) we focus our tests to the Eurozone area
Summary
The main monetary policy approach since the 1980s focuses on short-term interest rates; the role of monetary aggregates is reduced in the implementation of monetary policy. Reference [2] has linked the decline in the policy significance of monetary aggregates to the inherent problems of the naïve simple sum monetary aggregates: All monetary components are considered perfect substitutes at any given time and intertemporally. This type of aggregation has been criticized in the relevant literature since [3]. Reference [4] argues that internal inconsistency between this type of aggregation used to produce monetary aggregates and the economic theory used to produce the models within which the aggregates are used are responsible for the appearance of unstable demand and supply for money This discussion became known as the “Barnett Critique” [5,6]
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