Assignment

Money and Financial Markets

Q. Differentiate between simple sum and
weighted sum monetary aggregates. Which
one would you prefer as a measure of
money supply in the case of Indian
economy?
[7 +3]
A. The concept of a formal intermediate target for the
monetary policy emerged with the monetarist emphasis on
money targeting in the 1960s. In the 1970s, the evidence of a
stable relationship between money, output and prices,
encouraged central banks to give more weight to money
growth in their policy discussions, in an environment of
worsening inflation. In addition to supply (eg, oil price) shocks,
the high inflation in the 1970s was attributed to the
accommodative monetary policies pursued in many countries
to offset the adverse output and employment effects of the
shock. In this backdrop, a commitment to rules was thought
necessary to anchor inflation expectations. Thus arose the
need for monetary aggregates as intermediate targets
in the execution of a monetary policy.
Broadly speaking, there are two main types of monetary
aggregates, Simple sum monetary aggregates and Weighted
sum monetary aggregates. The two types shall be discussed in
detail further.
The Simple Sum monetary aggregates are derived by
simple summation of relevant monetary assets. Such
aggregates simply assume that each component is a perfect
substitute for the others in providing monetary services (eg,
currency and checkable demand deposits are assigned the
same weights). Furthermore, the narrow aggregate simple

sum M1 excludes both non-medium-of-exchange assets and

some assets with limited transaction characteristics.
The broader simple-sum aggregates, like M2, M3 and the
Feds broadest measure, total liquidity (L), include larger
amounts of non-medium-of-exchange assets. Consequently,
these broader simple-sum aggregates may misrepresent
significantly the monetary services provided by including nonmedium-of-exchange assets, which provide relatively low levels
of monetary services, on an equal footing with medium-of
exchange assets, which provide relatively high levels of
monetary services.
The Weighted sum monetary aggregates are based on the
principle of constructing monetary aggregates covering all
assets, weighted by their degree of 'moneyness'. The two
most prevalent weighted sum monetary aggregates include the
Monetary Services Index (MSI or the Divisia monetary
aggregate) and the MQ measure. The former is constructed,
specifically, by applying number theory to construct indexes of
financial assets that reflect the total utility, relative to some
base period, attributable to the monetary services obtained
from these assets. The latter (the MQ measure) is an index of
transaction assets whose weights are based on each asset's
turnover. Assets with relatively high turnover rates (in
purchasing final output) receive relatively larger weights.
The reason behind the evolution of weighted sum aggregates
from simple sum monetary aggregates is a theoretical and
conceptual one. Simple sum aggregates involve a simple sum
of a spectrum of monetary assets such as currency, demand
deposits, term deposits of various maturities etc. Such
aggregates would be meaningful only if the components of the
aggregates are perfect substitute for each other. In other
words, simple sum aggregation can be justified if none
of the monetary assets yield monetary return or all the
assets yield same return. In reality, however, component
assets excepting currency yield varying monetary return which
cannot be considered as flow of monetary services; hence, the
official measures of monetary aggregates especially at higher
level of aggregation contain an element of aggregation bias.
An important issue then becomes whether weighted monetary
aggregates are better intermediate policy targets than simple

sum aggregates like M1, which depends on which aggregate

has a close and predictable relationship with the objectives of
the economic policy. This further depends on how else these
two types of monetary aggregates contrast with each
other.
A financial innovation that results in a shift from assets not in
simple-sum M1 to assets in simple-sum M1 would cause the
same change in measured money, regardless of the source of
the shift. In contrast, similar innovations would cause
different changes in the MSI or MQ. The extent of the
impact depends on the difference between the asset's own rate
of return and that of the pure store-of-wealth asset (for the MSI)
and on the assets relative turnover rate in the purchase of
goods and services for MQI. As a result, theoretically, these new
aggregates may be affected less by innovations.
Also, MQ and broader MSI contain savings-type assets not
included in simple-sum M1 (eg, money market mutual funds).
Consequently, their growth rates would be affected less if the
growth in Negotiable Order of Withdrawal accounts (NOW)
resulted from a shift out of such deposits. If, however, most of
the growth in NOWs came from demand deposits, then simplesum M1 would be relatively unaffected and the growth of both
MQ and the MSI would decrease.
If we consider the predictability of velocity growth, studies have
shown that econometric forecasts of M1 velocity growth tend to
produce relatively large forecast errors. This result may be due
in part to the fact that velocity growth tends to fluctuate
randomly around a fixed mean, so that the expected future
growth rate in Ml velocity is unrelated to its past growth rates,
that is to say that M1 velocity possesses no regularities that will
enable it to be predicted on the basis of its own past history. If
a series contains such regularities, then its past history
provides some basis to predict its future, especially for
a short time into the future. If the growth rates of MQ
and MSI velocities also contain no such regularities,
then they will be just as difficult to predict as M1
velocity from their own past histories, and may be just as
difficult to predict from an econometric model as well.
In Indian Context:

Theoretically, weighted sum monetary aggregates may seem

superior to simple sum aggregates. Although, major studies in
the Indian context show that empirical attempts have not
succeeded in generating weighted monetary aggregates
that decisively outperform the simple sum aggregates.
The case for the use of weighted monetary aggregates in India
is, therefore, far from established. Inability of the weighted
aggregates to outperform the simple sum aggregates reflects
deficiencies of operationalisation rather than conceptualisation.
This also because the superiority of weighted monetary
aggregates over their simple sum counterparts depends
upon the structure of the financial markets. Under
repressed financial system, the interest rates on various
monetary assets are administered; suggesting that the
relative prices of most of the financial assets are constant over
time. Under such regime, weighted monetary aggregates tend
to converge to their simple sum counterparts. Therefore, earlier
studies concerning India, especially for the sample period
during which the interest rates were largely administered, failed
to establish the superiority of weighted monetary aggregates.
Broadly, three major inferences emerge from the earlier studies
in the Indian context.
1. In contrast to the theoretical arguments, simple sum
aggregates outperformed weighted aggregates even at higher
levels of aggregation.
2. The performance of weighted sum aggregates over their
simple sum counterparts are conditional upon sample period,
frequency of time series data and the context in which the role
of aggregates are evaluated and econometric tests used.
3. Even those studies that report supporting evidence in favour
of weighted sum monetary aggregates received severe
criticism on methodological grounds.
Even today the financial system in India remains on the
repressed side and though weighted sum monetary aggregates
flaunt superiority on paper, empirical evidence points to the
contrary. Therefore, for a continued stable relationship with the
overall objectives of monetary policy, simple sum monetary
aggregates are better suited as intermediate targets.

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