In this article, Enam Ahmed explains why central banks should use the Divisia approach to measure the effectiveness of the monetary policies. He argues that while the concept was developed almost a century ago, it remains a viable alternative to the tools used in modern economics. The idea to employ money supply growth as an indicator of policy effectiveness is hardly original, as the banks used this tool effectively until the 1980s when the new economic instruments made it unreliable. The main shortcoming of this method was that it failed to account for the liquidity of the assets. However, Ahmed believes that the Divisia index is viable in current circumstances because it is based on a more sophisticated approach to money supply measurement. Unlike the simple-sum index, the Divisia method takes into consideration the liquidity of the assets. For example, the same amount of money in cash and in a time deposit would be weighted differently in this system. Hence, the Divisia approach can be used for reliable economic forecasting because the components are weighted in accordance with their liquidity.
The main reason for implementing this method is the low reliability and effectiveness of the traditional tools in the current economic environment. Following the global financial crisis of 2008, the banks have been struggling to find a reliable indicator of their monetary policies’ effectiveness, and the Divisia index could prove to be the best solution to this problem. Narrow money supply measures used by some central banks provide minimal information, making economic forecasting unreliable. The Divisia approach, on the other hand, can be used to analyze all assets. Ahmed draws upon examples from different economies worldwide to support his point of view. In his opinion, the increase in Divisia money indicates the success of quantitative easing policies in the Eurozone and expansionary policies (such as lowering interest rates) in China.
References
Ahmed, E. (2016). The Better Way to Measure Money; We can now accurately quantify the money supply’s relationship to growth. The results will surprise you. The Wall Street Journal (online).