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

Author

Listed:
  • 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.

Suggested Citation

  • Gregory D. Hess & Charles S. Morris, 1995. "Money is what money predicts: the M* model of the price level," Research Working Paper 95-05, Federal Reserve Bank of Kansas City.
    • Handle: RePEc:fip:fedkrw:95-05
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    Citations

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    Cited by:

    1. Sean Collins & William C. Whitesell, 1996. "A minor redefinition of M2," Finance and Economics Discussion Series 96-7, Board of Governors of the Federal Reserve System (U.S.).
    2. Martha Misas A. & Enrique López E. & Luis Fernando Melo V., 1999. "La inflación desde una perspectiva monetaria: un modelo P* para Colombia," Revista ESPE - Ensayos sobre Política Económica, Banco de la Republica de Colombia, vol. 0(35), pages 5-53, June.
    3. Clostermann Jörg & Seitz Franz, 2002. "Money, Inflation and Growth in Germany. A Vector-Error-Correction-P-Star Model / Der Zusammenhang zwischen Geldmenge, Output und Preisen in Deutschland. Ein Vektorfehlerkorrektur-P-Star-Ansatz," Journal of Economics and Statistics (Jahrbuecher fuer Nationaloekonomie und Statistik), De Gruyter, vol. 222(6), pages 641-655, December.

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    Keywords

    Money; Money supply;

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