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Money is what money predicts: the M* model of the price level

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  • Gregory D. Hess
  • Charles S. Morris

Abstract

Over the past twenty years, the monetary aggregates used by the Federal Reserve as indicators of economic activity and inflation have changed several times. Each of the changes in the measures of money was sparked by a breakdown in the fit of empirical money demand functions. The Federal Reserve's strategy following these breakdowns has been to redefine money by simply adding new assets to the old definitions. The criterion in each case was whether adding the new assets produced an empirically stable money demand function. Unfortunately, while a stable demand for money is a worthwhile ultimate goal, history has demonstrated that it is also an elusive one. ; In this paper, we propose an alternative objective for identifying a useful monetary aggregate--the price level. Our monetary aggregate is a weighted-sum aggregate where the weights on the component assets vary across assets and over time such that the aggregate is the best predictor of the price level. The only assumption made in choosing the weights is that the Quantity Theory of Money holds in the long run. We find that the new monetary aggregate, M*, has a stable velocity in the long run and that it predicts the long-run price level and rate of inflation better than M2.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number 95-05.

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Date of creation: 1995
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Handle: RePEc:fip:fedkrw:95-05

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Keywords: Money ; Money supply;

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Cited by:
  1. Martha Misas Arango & Enrique López Enciso & Luis Fernando Melo velandia, 1999. "La Inflación Desde Una Perspectiva Monetaria : Un Modelo P* Para Colombia," BORRADORES DE ECONOMIA 003028, BANCO DE LA REPÚBLICA.
  2. William Whitesell & Sean Collins, 1996. "A minor redefinition of M2," Finance and Economics Discussion Series 96-7, Board of Governors of the Federal Reserve System (U.S.).

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