A granular investigation on the stability of money demand

This 2024 Macroeconomic Dynamics paper by Zhengyang Chen and Victor J. Valcarcel asks whether the long-documented instability of U.S. money demand reflects a genuine structural break in households’ and firms’ preferences for monetary assets, or is instead an artifact of measuring money with simple-sum aggregates (which just add up dollar balances) rather than Divisia aggregates (which weight each monetary asset by its real user cost, i.e., the foregone return from holding it instead of a benchmark asset). Using monthly U.S. data from January 1967 to March 2020 (the sample stops there because the Federal Reserve’s April 2020 redefinition of M1 and a simultaneous Center for Financial Stability accounting change make later observations non-comparable), the authors estimate bivariate Johansen (1991, 1995) cointegrating VECMs between real money balances scaled by nominal income and an opportunity-cost variable – either the 3-month T-bill yield or each aggregate’s own Divisia real user cost – in both semi-log (Cagan) and double-log (Meltzer) functional forms, checked across four Johansen trend specifications and corroborated with Andrews-Ploberger (1994) and Bai-Perron (2003) structural-break tests. They find that simple-sum M2 and M3 fail to cointegrate with the T-bill yield over the full sample, whereas Divisia M2 cointegrates robustly with its own user cost under every specification and functional form, and Divisia M3 cointegrates under most specifications; splitting the sample at the 1980 DIDMCA deregulation break (located via Andrews-Ploberger at 1979:M10 for Divisia M2 and 1980:M2 for Divisia M3) shows simple-sum M2’s relationship with the T-bill yield breaking down after 1980 (surviving only in trend specifications, and then with the wrong sign), while Divisia M2 continues to cointegrate correctly in both subperiods. After the Global Financial Crisis, the near-zero T-bill yield loses its cointegrating relationship with Divisia M3 and M4 entirely, yet both continue to cointegrate with their own real user costs, which never collapsed to zero. A granular decomposition of ten individual Divisia components against their own user costs finds that 29 of 40 estimated coefficients (10 components times 4 Johansen criteria) carry the theoretically correct sign, versus much weaker and more often wrong-signed cointegration between those same components and the T-bill yield. The authors conclude that the instability documented in the money-demand literature is a matter of measurement – the T-bill yield and simple-sum aggregation strip out information that Divisia aggregation and its user costs preserve – rather than a structural shift in money demand itself; scope is limited throughout to bivariate (two-variable) cointegrating relationships, with income elasticity imposed as unity rather than estimated.

Macroeconomic Dynamics | Macro Paper Warehouse

A granular investigation on the stability of money demand