The Demand for Money for EMU: a Flexible Functional Form Approach

Abstract

Monetary aggregates have a special role under the “two pillar strategy” of the ECB. Hence, a theoretically consistent measure of monetary aggregates for the European Monetary Union (EMU) is needed. This paper analyzes aggregation over monetary assets for the EMU. We aggregate over the monetary services for the eleven EMU (EMU-11) countries, which include Estonia, Finland, France, Germany, Ireland, Italy, Luxembourg, Malta, Netherlands, Slovakia, and Slovenia. We adopt the Divisia monetary aggregation approach, which is consistent with index number theory and microeconomic aggregation theory. The result is a multilateral Divisia monetary aggregate, in accordance with Barnett (J Econ 136(2):457–482, 2007). The multilateral Divisia monetary aggregate for the EMU-11 is found to be more informative and a better signal of economic trends than the corresponding simple sum aggregate. We then analyze substitutability among monetary assets for the EMU-11 within the framework of a representative consumer’s utility function, using Barnett’s (J Bus Econ Stat 1:7–23, 1983) locally flexible functional form, the minflex Laurent indirect utility function. The analysis of elasticities with respect to the asset’s user-cost prices shows that: (i) transaction balances and deposits with agreed maturity are income elastic and (ii) the monetary assets are not good substitutes for each other within the EMU-11. Simple sum monetary aggregation assumes that component assets are perfect substitutes. Hence simple sum aggregation distorts measurement of the monetary aggregate. The ECB provides Divisia monetary aggregates to the Governing Council at its meetings, but not to the public. Our European Divisia monetary aggregates will be expanded and refined, in collaboration with Wenjuan Chen at the Humboldt University of Berlin, to a complete EMU Divisia monetary aggregates database to be supplied to the public by the Center for Financial Stability in New York City.

Appendices

Appendix 1

Definitions:

Monetary and financial institutions (MFI) from the ECB Glossary: MFIs are Central Bank, resident credit institutions as defined by community law, and other resident financial institutions whose business is to receive deposits and /or close substitutes for deposits from entities other than MFIs and for their own account to grant credits and/or make investments in securities.

Overnight deposits from the ECB Glossary, deposits with next-day maturity: This instrument category comprises mainly those sight/demand deposits that are fully transferable by check or similar instrument. It also includes non-transferable deposits that are convertible on demand or by close of business the following day. Overnight deposits are included in M1 and hence in M2 and M3.

Deposits redeemable at notice (DRN) from the ECB Glossary: These deposits are savings deposits for which the holder must respect a fixed period of notice before withdrawing the funds. In some cases there is the possibility of withdrawing on demand a certain fixed amount in a specified period or of early withdrawal subject to the payment of a penalty. Deposits redeemable at a period of notice up to three months are included in M2 and hence in M3, while those with a longer period of notice are part of the non-monetary longer term financial liabilities of the MFI sector.

Deposits with an agreed maturity (DAM) from the ECB Glossary: These deposits are mainly time deposits with a given maturity that, depending on national practices, may be subject to the payment of a penalty in the event of early withdrawal. Some non-marketable debt instruments, such as non-transferable retail certificates of deposit, are also included. Deposits with an agreed maturity of up to two years are included in M2 and hence in M3, while those with an agreed maturity of over two years are included in the non-monetary long term financial liabilities of the MFI sector.

Non-profit institutions serving households (NPISH) from the Eurostat Glossary: These institutions make up an institutional sector in the context of national accounts consisting of non-profit institutions which are not mainly financed and controlled by government and which provide goods or services to households for free or at prices that are not economically significant. Examples include churches and religious societies, sports and other clubs, trade unions, and political parties. NPISH are private, non-market producers which are separate legal entities. Their main resources, apart from those derived from occasional sales, are derived from voluntary contributions in cash or in kind from households in their capacity as consumers, from payments made by general governments, and from property income.

Non-financial corporation (NFC) from the ECB Glossary: These firms are corporation or quasi-corporation that is not engaged in financial intermediation but is active primarily in the production of market goods and non-financial services.

Appendix 2

The M1 monetary aggregate contains the most liquid monetary asset components. The ECB has defined the M1 monetary aggregate to include currency in circulation and overnight deposits. Overnight deposits are deposits with next-day maturity and comprises mainly of sight deposits or demand deposits which are fully transferable by check or similar instruments. The ECB definition of the M2 aggregate includes currency in circulation, overnight deposits, deposits with agreed maturity (DAM) up to 2 years and deposits redeemable at notice (DRN) up to 3 months. The data on currency in circulation is taken from the individual countries’ central banks, as currency held by banks. The ECB website does not provide the data on currency in circulation. The data for the outstanding amount of OD, DAM, and DRN are for the households and non-profit institutions serving households. The data for the interest rate for OD, DAM and DRN are the Monetary Financial Institutions (MFI) interest rates for the households and non-profit institutions serving households. Currency is assumed is to have a zero own rate of return. The outstanding amount and interest rate data for OD, DAM and DRN are from the ECB Data Warehouse.

The benchmark rate is the expected rate of return received on a pure investment providing no services other that its yield. In short, the benchmark rate is the rate of return on pure capital. Since it provides no services other than its yield, the benchmark rate must be at least as high as the upper envelope over all the monetary aggregate’s component yield-curve-adjusted rates of return. In that upper envelope, we also include the interest rate on loans of maturity of up to one year.

In case of a few countries like Finland, France, and the Netherlands, the interest rate on deposits with agreed maturity of 2 years was greater than the loan rate for a few months. For those periods, 100 basis points were added to the upper envelope to keep the user costs from becoming zero. This procedure is in accordance with Anderson and Jones (2011). In the case of Finland, the interest rate on DAM was higher than the loan rate for two periods of up to one year. For DAM and DRN, those periods were January 2009 to September 2009 and March 2012 to October 2012. For those periods, 0.01 point is added to the loan rate, so that the benchmark rate is highest of all the rates of return on monetary assets. The corresponding periods for France are March 2009 to January 2011 and December 2011 to January 2011. For the Netherlands, the periods are January 2009 to June 2010 and January 2012 to October 2013.