No. 223 - Measuring Money with a Divisia Index: An Application to Italy

The use of a weighted monetary index has been proposed in the economic literature to take account of the different degrees of liquidity of the short-term instruments included in "money". In this paper, the approach is applied to the Italian monetary aggregates; the performance of the index is then tested using vector autoregressions and cointegration techniques. The evidence shows that a Divisia index is a good monetary indicator. Until the mid-eighties, its behavior is very similar to that of traditional M2; however, the two measures of liquidity increasingly diverge in recent years, as a result of financial innovation on the liability side of banks' balance sheets. In this period, the index provides additional information, relative to M2, on real GDP and prices; it indicates a slower growth of liquidity than M2 does.