The Divisia monetary indicator and the money supply definition

By Dr Frank Shostak

By most commentators, since the early 1980s, correlations between various definitions of money and national income have broken down. The reason for this breakdown, it is held, is financial deregulation that made the demand for money unstable. Because of financial deregulation the nature of financial markets has changed; consequently, past definitions of money no longer hold. 

As a result, it is held the usefulness of money as a predictor of economic events has significantly diminished. Note that according to popular thinking the definition of money is not something permanent but of a flexible nature. Sometimes it could be M1 and at another time, it could be M2. What dictates whether M1, M2 or some other M will be labelled as money is the correlation with national income. 

Note again that according to popular thinking, the validity of various definitions of money can be ascertained by means of quantitative methods. What determines whether money M1, M2, and the other Ms are valid definitions is how well they correlate with various key economic data such as the gross domestic product.

Some commentators are of the view that a major factor behind the breakdown in the correlation between money supply and national income is not so much financial deregulation but rather an unsound methodology of measuring the monetary aggregates.

On this way of thinking the monetary aggregates presented by the Fed is a sum of its monetary components in which the components are assigned the same weight. For instance, the components of the money supply definition M2 comprises of cash, checking deposits, savings deposits, money market securities, mutual funds, and other time deposits.

It is however argued that such a summation does not weigh components in a way that properly summarizes the services of each monetary component of money. On this way of thinking, conventional money-supply measures do not account for differences in the degree to which various assets actually serve as money. 

The Divisia indicator, named after the early 20th-century French economist, Francois Divisia, makes adjustments for differences in the degree to which various components of the monetary aggregate serve as money. This in turn it is held offers a more accurate picture of what is really happening to money supply.  

The primary Divisia monetary data for the US is money M4. It is a broad aggregate, which includes negotiable money-market securities, such as commercial paper, negotiable CDs, and T-bills. By assigning variable rather than equal weights to the money supply components, it is held, that one could remedy the issue of an unstable money demand.  By assigning suitable weights by means of quantitative methods, it is held that one is likely to improve the correlation between the weighted monetary gauge and various economic indicators. Consequently, one could employ this monetary measure to ascertain the future course of key economic indicators. 

However, does it all make sense? 

Defining what money is

We hold that no definition can be established by means of a correlation. The purpose of a definition is to present the essence the distinguishing characteristic of the subject we are trying to identify. The definition is expected to tell us what the fundamentals of a particular entity are. 

To establish the definition of money we have to ascertain how a money-using economy came about. Money emerged as a result of the fact that barter could not support the market economy. A butcher who wanted to exchange his meat for fruit might have difficulties to find a fruit farmer who wanted his meat, while the fruit farmer who wanted to exchange his fruit for shoes might not been able to find a shoemaker who wanted his fruit. The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity. 

On this Mises wrote,

There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money. (1980, p. 45) (Mises, Ludwig von. 1980. The Theory of Money and Credit. Indianapolis, Ind.: Liberty Classics.)    

Observe money is that for which all other goods and services are traded. This fundamental characteristic of money must be contrasted with those of other goods. For instance, food supplies the necessary energy to human beings, while capital goods permit the expansion of infrastructure that in turn permits the production of a larger quantity of goods and services. 

Through an ongoing selection process over thousands of years, people have settled on gold as money. Gold served as the standard money. In today’s monetary system, the money supply is no longer gold but coins and notes issued by the government and the central bank. Consequently, coins and notes constitute the standard money, known as cash that is employed in transactions. Goods and services are bought and sold for cash. Note again that the essence of money is that for which all other goods and services are traded. Also, note that the essence of money remains the same irrespective of financial deregulations. 

Distinction between claim and credit transactions

At any point in time, an individual can keep his money in his wallet, at home or deposit the money with a bank. In depositing his money, an individual never relinquishes his ownership over the money. No one else is expected to make use of it. 

When Joe deposits his money with a bank, he continues to have an unlimited claim against it and is entitled to take charge of it at any time. Consequently, these deposits, labelled demand deposits, are part of money. At any point in time if in an economy individuals hold $10,000 in cash, we would say that the money supply in this economy is $10,000. 

Now, if some individuals have stored $2,000 in demand deposits, the total money supply will still remain $10,000: $8,000 in cash and $2,000 in demand deposits—that is, $2,000 cash is stored in bank demand deposits. Finally, if individuals deposit their entire stock of cash, the total money supply will remain $10,000, all of it in demand deposits. 

This must be contrasted with a credit transaction, in which the lender of money relinquishes his claim over the money for the duration of the loan. As a result, in a credit transaction, money is transferred from a lender to a borrower. 

Credit transaction does not alter the amount of money. If Bob lends $1,000 to Joe, the money is transferred from Bob’s demand deposit or from Bob’s wallet to the Joe’s possession. 

Why various popular definitions of money are questionable?

Consider the money M2 definition. This definition includes money market securities, mutual funds and other time deposits. However, investing in a mutual fund is in fact an investment in various money market instruments. The quantity of money is not altered as a result of this investment; only the ownership of money has temporarily changed. 

Thus, if Joe invests $1,000 with a mutual fund, the overall amount of money in the economy will not change as a result of this transaction. Money will move from Joe’s demand deposit account to the demand deposit account of the mutual fund with a bank. To incorporate the $1,000 invested with the mutual fund into the definition of money would amount to double counting. Again, the investment of $1000 in the mutual fund did not generate additional money that should be included in the money definition.

We suggest that the money of zero maturity (MZM) definition also does not help identifying what money is. The essence of the MZM is that it encompasses financial assets with zero maturity. Assets included in the MZM are redeemable at par on demand. This definition excludes all securities, which are subject to risk of capital loss, and time deposits, which carry penalties for early withdrawal.  

The MZM includes all types of financial instruments that can be easily converted into money without penalty or risk of capital loss. Observe that MZM includes assets that can be easily converted into money. This is precisely what is wrong with this definition, since it does not identify money but rather various assets that can be easily converted into money. It does not tell us what money actually is. This is what a definition of money is supposed to do.  

Observe that the Divisia monetary gauge is not of much help either in establishing what money is. Please note that this indicator was designed to strengthen the correlation between monetary aggregates such as M4 and other M’s with an economic activity indicator. In fact, by this logic the change in weights of various components of money as a result of financial innovations can lead to an ongoing change of the definition of what money is. In this sense, the construction of the Divisia gauge is an exercise in curve fitting.  

We suggest that by replacing the equal weights components of the popular money supply definitions with variable weights one does not establish the essence of what money is. 

Again, the Divisia M4 or the Divisia of other M’s are employed with the view that it will enable a reliable forecast of some key economic data. The Divisia of various M’s such as the Divisia M4 does not address the double counting of money issue. 

Note again that the M4 is a broad aggregate, which includes cash plus negotiable money-market securities, such as commercial paper, negotiable CDs, and T-bills. What we have here is a mixture of claim and credit transactions i.e. a double counting of money. This generates a misleading picture of what money truly is. Applying various weights to the components of money cannot make the definition of money valid if the definition comprises of erroneous components. 

The current practice of including various assets into the definition of money because of their liquidity is questionable. In some cases, inventories of retail goods might be as liquid as stocks or bonds. However, no one would consider these inventories as part of the money supply. In fact, they are other goods that sold for money in the market. Observe, that liquid assets like stocks and bonds in similarity to other goods and services are exchanged for money i.e., other goods are not exchanged for these assets.   

We hold that once it is established that the definition of money is sound one must stick to it regardless of whether it is well correlated with some other economic data or not. Thus regardless of the correlation we can say that an increase in money supply sets in motion an exchange of nothing for something. This in turn results in the diversion of wealth from wealth generators towards non-wealth generating activities. In the process, this sets in motion the menace of the boom-bust cycle. Hence, by observing the correctly defined money supply an analyst can establish an important economic information. 

The introduction of electronic money has supposedly introduced another confusion regarding the definition of what money is. It is held that the electronic money is likely to make the current money i.e. cash redundant. We suggest that the various forms of electronic moneys do not have a “life of their own.” Electronic money can function as money as long as individuals know that they can obtain cash on demand. Various financial innovations do not generate a new form of money, but rather the new ways of employing existing money in transactions. Regardless of these financial innovations, the nature of money does not change. It is that for which all other goods and services are traded for.  


The attempt to strengthen the correlation between various monetary aggregates such as M4 and economic activity by means of a variable weighting of the money supply components defeats the formulation of the definition of money. The essence of what money is cannot be established by means of a statistical correlation but rather by means of understanding what money is all about. 

Once the valid definition of money is established then one can ascertain various outcomes on account of changes in money supply. These outcomes are going to emerge regardless of the correlation between money and the key economic data. Thus, we know that increases in money supply are going to set in motion the process of economic impoverishment. Hence, it is important to have a valid definition of what money is in order to establish its effect on the economy. By combining claim and credit transactions into the monetary aggregate such as M4, one generates confusion rather than clarity regarding the state of money supply. Note again that a variable weight monetary gauge such as the Divisia indicator is not a substitute for the correct definition of what money is.

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