A Granular Investigation on the Stability of Money Demand
A Granular Investigation on the Stability of Money Demand
Abstract
A large literature has shown money demand functions constructed from simplesum aggregates are unstable. We revisit the controversy surrounding the instability of money demand by examining cointegrating income-money relationships with the Divisia monetary aggregates for the U.S., and compare them with their simple-sum counterparts. We innovate by conducting a more granular analysis of various monetary assets and their associated user costs. We find characterizing money demand with simple-sum measures only works well in a period preceding 1980. Divisia aggregates, their components, and their user costs provide a more reliable interpretation of money demand. Subsample analysis across 1980 and 2008 suggests the instability of money demand is a matter of measurement rather than a consequence of a structural change in agents’ preference for monetary assets.
Analysis of Money Demand Stability: A Comprehensive Review of Divisia vs Simple-Sum Monetary Aggregates
Overview
This paper “A granular investigation on the stability of money demand” by Zhengyang Chen (University of Northern Iowa) and Victor J. Valcarcel (University of Texas at Dallas) tackles one of the most enduring puzzles in monetary economics: why did the relationship between money and economic activity appear to break down after 1980? Their findings suggest that the problem wasn’t that people’s preferences for money changed, but rather that economists were measuring money incorrectly.
The Money Demand Problem
Since the early 1990s, central banks and economists have largely abandoned using monetary aggregates (measures of the money supply like M1, M2, M3) in their policy decisions. This shift occurred because the previously stable relationship between these measures and key economic variables like interest rates and income appeared to collapse dramatically after 1980.
Money demand refers to how much money people and businesses want to hold for transactions and as a store of value. Economic theory suggests this demand should be predictably related to factors like income (more income = more money needed for transactions) and interest rates (higher rates = less attractive to hold non-interest-bearing money).
The breakdown of this relationship led influential researchers like Friedman and Kuttner (1992) and Bernanke and Blinder (1992) to conclude that monetary policy should focus exclusively on interest rates rather than money supply measures.
The Measurement Problem
The authors argue that the instability wasn’t due to fundamental changes in how people use money, but rather stems from how economists measure money. Traditional simple-sum aggregates treat all forms of money as perfect substitutes—a dollar in a checking account is counted the same as a dollar in a savings account or money market fund, regardless of their different liquidity properties or interest rates.
This approach became increasingly problematic after the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980, which allowed banks to pay interest on checking accounts and created new types of interest-bearing deposits. Suddenly, monetary assets that had previously been clearly distinct began offering different yields and serving different functions.
The Divisia Alternative
The paper advocates for Divisia monetary aggregates, developed by William Barnett (1978, 1980), which weight different monetary assets according to their liquidity services rather than treating them as perfect substitutes. These measures also incorporate user costs—essentially the opportunity cost of holding each type of monetary asset.
User cost is calculated as the difference between the yield on a benchmark asset (like Treasury bills) and the yield on the monetary asset itself, divided by one plus the benchmark rate. This captures the true “price” of the liquidity services that money provides.
The mathematical foundation comes from microeconomic theory, where households maximize utility from monetary services subject to a budget constraint, similar to how they choose among consumer goods.
Key Findings
1. Divisia Aggregates Show Stable Money Demand
Using cointegration analysis (a statistical technique for identifying long-run relationships between economic variables), the authors find that:
Simple-sum aggregates show unstable or non-existent relationships with interest rates after 1980
Divisia aggregates maintain stable, statistically significant relationships with their user costs throughout the entire sample period (1967-2020)
2. The 1980 Break Was Real for Simple-Sum Measures
Statistical tests confirm a structural break around 1980 for simple-sum measures, coinciding with financial deregulation. However, Divisia measures show continued stability across this period.
3. User Costs Outperform Treasury Bill Rates
The paper demonstrates that Divisia user costs provide better measures of the opportunity cost of holding money than traditional short-term interest rates like the 3-month Treasury bill yield. This is particularly important during periods like 2008-2015 when Treasury rates were near zero due to the zero lower bound policy, while user costs remained meaningful.
4. Granular Analysis Reveals Component Differences
In an innovative contribution, the authors examine individual components of the monetary aggregates (currency, demand deposits, savings deposits, money market funds, etc.) and their relationships with their respective user costs. They find:
Traditional assets like currency and demand deposits show strong relationships with their user costs
Newer financial instruments created after 1980 show weaker relationships with Treasury rates but stronger relationships with their own user costs
This supports the theoretical superiority of user costs over market interest rates
Implications for Monetary Policy
The findings suggest that monetary aggregates shouldn’t have been abandoned by central banks. Instead, the problem was using the wrong measures. Properly constructed Divisia aggregates provide stable, reliable information about money demand that could inform monetary policy decisions.
This is particularly relevant given recent interest in monetary factors following unconventional policies like quantitative easing. As Belongia and Ireland (2016, 2018, 2019) and others have argued, bringing “money back in” to monetary policy analysis may improve our understanding of how policy affects the economy.
Technical Innovation
The paper makes several methodological contributions:
- Comprehensive cointegration analysis using the Johansen (1995) framework with various specifications for deterministic trends
- Subsample analysis around key structural break points (1980, 2008)
- Granular component analysis examining individual asset relationships
- Functional form comparison between semi-log and double-log specifications
Broader Context
This work contributes to a growing literature rehabilitating the role of money in macroeconomics, including important contributions by:
Serletis (1991) and Serletis and Gogas (2014) on Divisia money demand
Belongia and Ireland’s extensive work on monetary policy with Divisia aggregates
Barnett et al. (2022) on monetary aggregate stability
Lucas and Nicolini (2015) on alternative money measures
Conclusion
The paper’s central message is that “the instability of money demand is a matter of measurement rather than a consequence of a structural change in agents’ preference for monetary assets.” This has profound implications for both monetary theory and policy, suggesting that properly measured money remains a useful guide for central banks.
The authors demonstrate that by using theoretically grounded Divisia aggregates and their associated user costs, the stable money demand relationships that economists relied on for decades can be restored, even in our modern financial system with its complex array of monetary instruments.
Chen, Z., & Valcarcel, V. J. (2025). A granular investigation on the stability of money demand. Macroeconomic Dynamics, 29, e40. https://doi.org/10.1017/S1365100524000427
📚 Academic Citations & Literature Review
Papers and Topics That Could Cite Chen & Valcarcel (2024)
Chen, Z., & Valcarcel, V. J. (2025). A granular investigation on the stability of money demand. Macroeconomic Dynamics, 29, e40. https://doi.org/10.1017/S1365100524000427
1. Monetary Policy and Central Banking
Monetary Policy Transmission Mechanisms
Papers examining how monetary policy affects the economy through money supply channels
Studies on the relative importance of interest rate vs. quantity channels in monetary transmission
Research on unconventional monetary policies (QE, forward guidance) and their effects on money demand
Cross-country studies of monetary policy effectiveness
Central Bank Communication and Strategy
Papers on central bank intermediate targets (money growth vs. inflation targeting)
Studies on the Federal Reserve’s evolution from monetary targeting to interest rate targeting
Research on ECB, Bank of Japan, or other central banks’ monetary strategies
Papers on central bank credibility and the role of monetary aggregates in communication
Monetary Policy Rules and Models
Research extending Taylor rules to include monetary aggregates
DSGE models incorporating money and testing their empirical fit
Studies comparing policy rules with and without monetary indicators
Papers on optimal monetary policy under uncertainty about money demand
2. Money Demand and Monetary Economics
Money Demand Specifications and Estimation
Papers testing alternative functional forms for money demand (beyond semi-log and double-log)
Studies using panel data or cross-country analysis of money demand stability
Research on money demand in developing countries or emerging markets
Papers on money demand during financial crises or unusual economic periods
Divisia Monetary Aggregates
Studies constructing Divisia aggregates for other countries
Papers comparing different weighting schemes in monetary aggregation
Research on the theoretical foundations of monetary aggregation
Studies on Divisia aggregates and financial innovation
Interest Rate and User Cost Analysis
Papers on the term structure of user costs for monetary assets
Studies comparing different measures of opportunity cost in money demand
Research on user costs during zero lower bound periods
Papers on the relationship between user costs and monetary policy
3. Financial Innovation and Regulation
Financial Deregulation Studies
Papers examining the effects of banking deregulation in other countries
Studies on the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980
Research on the relationship between financial innovation and monetary stability
Papers on the unintended consequences of financial deregulation
Digital Currencies and Fintech
Studies on how cryptocurrencies affect traditional money demand
Research on central bank digital currencies (CBDCs) and their impact on monetary aggregates
Papers on fintech innovations and their effects on monetary transmission
Studies on mobile payments and digital wallets in money demand
Banking Sector Evolution
Papers on the changing role of banks in monetary policy transmission
Studies on shadow banking and its effects on monetary measures
Research on bank regulation and its impact on money creation
Papers on banking consolidation and monetary aggregates
4. Econometric Methodology and Time Series Analysis
Cointegration and Structural Breaks
Papers applying similar cointegration methods to other economic relationships
Studies on structural break testing in monetary or financial time series
Research on cointegration with regime changes or smooth transitions
Papers comparing different cointegration methodologies
Unit Root and Stationarity Testing
Studies using DF-GLS or other unit root tests in monetary contexts
Research on the time series properties of financial variables
Papers on testing for multiple structural breaks in economic time series
Studies on the persistence of monetary policy effects
Time-Varying Parameter Models
Papers using state-space models for money demand estimation
Studies on time-varying coefficients in monetary relationships
Research on Markov-switching models in monetary economics
Papers on threshold cointegration in money demand
5. Macroeconomic Modeling and Forecasting
Macro Forecasting with Monetary Variables
Studies on the forecasting power of Divisia vs. simple-sum aggregates
Research on including monetary variables in macro forecasting models
Papers on nowcasting economic activity using monetary data
Studies on the predictive content of monetary aggregates for inflation
Business Cycle Analysis
Papers on the role of money in business cycle fluctuations
Studies on monetary factors in recession prediction
Research on the relationship between monetary aggregates and output gaps
Papers on monetary transmission over the business cycle
DSGE and Macroeconomic Models
Studies incorporating Divisia aggregates into DSGE models
Research on microfounding monetary aggregates in macro models
Papers on the role of money in New Keynesian models
Studies comparing model performance with different monetary measures
6. International Monetary Economics
Exchange Rates and International Money Demand
Studies on money demand in open economy contexts
Research on currency substitution and international monetary aggregates
Papers on the effects of exchange rate regimes on money demand stability
Studies on global liquidity and international monetary transmission
Comparative Monetary Systems
Papers comparing money demand across different monetary regimes
Studies on money demand in dollarized economies
Research on currency unions and monetary aggregation
Papers on emerging market money demand and financial development
International Capital Flows
Studies on how capital flows affect domestic money demand
Research on the relationship between monetary aggregates and capital account openness
Papers on global financial cycles and domestic monetary conditions
Studies on spillovers from foreign monetary policy
7. Financial Market Studies
Asset Pricing and Portfolio Theory
Papers incorporating user costs into asset pricing models
Studies on the portfolio approach to money demand
Research on the substitutability between monetary and financial assets
Papers on the role of monetary assets in portfolio diversification
Banking and Financial Intermediation
Studies on bank deposit behavior and monetary aggregates
Research on the relationship between banking sector health and money demand
Papers on deposit insurance and its effects on monetary stability
Studies on interest rate pass-through and monetary transmission
Financial Stability and Crisis Analysis
Papers on early warning indicators using monetary aggregates
Studies on money demand during financial crises (2008, COVID-19, etc.)
Research on the relationship between monetary instability and financial crises
Papers on unconventional monetary policy and financial stability
8. Behavioral and Microeconomic Foundations
Household Finance and Money Demand
Studies on microeconomic foundations of aggregate money demand
Research using household-level data to understand money holding behavior
Papers on the heterogeneity of money demand across different groups
Studies on the behavioral economics of cash and deposit holding
Firm-Level Money Demand
Research on corporate cash management and monetary aggregates
Studies on the business sector’s contribution to money demand
Papers on working capital needs and monetary transmission
Research on firm heterogeneity in money demand
9. Policy Evaluation and Historical Analysis
Historical Monetary Policy Analysis
Papers on the Volcker disinflation and its effects on money demand
Studies on the Great Moderation and monetary stability
Research on the role of monetary aggregates in past policy episodes
Papers on lessons from monetary targeting experiments
Policy Evaluation Studies
Research evaluating the costs and benefits of abandoning monetary targets
Studies on the effectiveness of inflation targeting vs. monetary targeting
Papers on the welfare implications of different monetary policy frameworks
Research on the social costs of monetary instability
10. Specialized Applications
Environmental and Energy Economics
Studies on the relationship between energy prices and money demand
Research on environmental policy and monetary transmission
Papers on carbon pricing and its effects on monetary aggregates
Labor Economics
Studies on the relationship between labor market conditions and money demand
Research on wage dynamics and monetary transmission
Papers on employment effects of monetary policy through money channels
Public Finance
Research on government debt and its effects on money demand
Studies on fiscal-monetary interactions and monetary aggregates
Papers on seigniorage and optimal monetary policy
Development Economics
Studies on money demand in developing countries with limited financial systems
Research on financial inclusion and monetary aggregates
Papers on mobile money and traditional monetary measures in developing economies
Citation Contexts
Papers citing this work might reference it in several ways:
As foundational evidence for the superiority of Divisia aggregates
For methodological approaches to testing money demand stability
As support for including monetary factors in policy models
For empirical evidence on the 1980 structural break in US monetary relationships
As motivation for reconsidering the role of money in central banking
For the granular analysis approach to understanding aggregate relationships
As evidence that measurement matters more than structural change in economic relationships
Papers Relevant to Chen & Valcarcel (2024)
Chen, Z., & Valcarcel, V. J. (2025). A granular investigation on the stability of money demand. Macroeconomic Dynamics, 29, e40. https://doi.org/10.1017/S1365100524000427
Foundational Divisia and Monetary Aggregation Theory
Barnett, W. A. (1980). Economic monetary aggregates an application of index number and aggregation theory. Journal of Econometrics, 14(1), 11-48.
This seminal paper establishes the theoretical foundation for Divisia monetary aggregates that Chen & Valcarcel build upon. Barnett’s work provides the microeconomic justification for weighting monetary assets by their user costs rather than treating them as perfect substitutes.
Barnett, W. A. (1978). The user cost of money. Economics Letters, 1(2), 145-149.
The original formulation of the user cost concept that is central to Chen & Valcarcel’s analysis. This paper introduces the formula for calculating the opportunity cost of holding monetary assets that forms the basis for Divisia price duals.
Money Demand Instability Literature
Friedman, B. M., & Kuttner, K. N. (1992). Money, income, prices, and interest rates. American Economic Review, 82(3), 472-492.
This influential paper documented the breakdown of traditional money demand relationships after 1980 and contributed to the Federal Reserve’s shift away from monetary targeting. Chen & Valcarcel directly challenge this conclusion by showing that properly measured Divisia aggregates remain stable.
Stock, J. H., & Watson, M. W. (1993). A simple estimator of cointegrating vectors in higher order integrated systems. Econometrica, 61(4), 783-820.
This methodological paper provides the econometric framework that Chen & Valcarcel use for their cointegration analysis. The authors apply Stock-Watson methods to test for long-run relationships between monetary aggregates and interest rates.
Ball, L. (2001). Another look at long-run money demand. Journal of Monetary Economics, 47(1), 31-44.
Ball’s work extends the analysis of money demand instability into the 1990s, finding continued breakdown of simple-sum relationships. Chen & Valcarcel’s findings suggest that Ball’s conclusions would have been different had he used Divisia measures.
Cointegration and Time Series Methodology
Johansen, S. (1991). Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models. Econometrica, 59(6), 1551-1580.
The core econometric methodology employed by Chen & Valcarcel for testing long-run relationships between monetary aggregates and interest rates. The Johansen framework allows them to rigorously test for cointegration under different assumptions about deterministic trends.
Johansen, S. (1995). Identifying restrictions of linear equations with applications to simultaneous equations and cointegration. Journal of Econometrics, 69(1), 111-132.
This extension of the Johansen method provides the framework Chen & Valcarcel use to test restrictions on their cointegrating equations. The 1995 methodology allows for more nuanced testing of money demand specifications.
Elliott, G., Rothenberg, T. J., & Stock, J. H. (1996). Efficient tests for an autoregressive unit root. Econometrica, 64(4), 813-836.
Chen & Valcarcel employ the DF-GLS unit root test developed in this paper to establish the time series properties of their monetary and interest rate variables. This testing is crucial for validating their cointegration analysis.
Structural Breaks and Financial Deregulation
Andrews, D. W. K., & Ploberger, W. (1994). Optimal tests when a nuisance parameter is present only under the alternative. Econometrica, 62(6), 1383-1414.
Chen & Valcarcel use the Andrews-Ploberger test to formally identify structural breaks around 1980, providing statistical confirmation of the timing of money demand instability. This methodology supports their argument that the break coincides with financial deregulation.
Bai, J., & Perron, P. (2003). Critical values for multiple structural change tests. The Econometrics Journal, 6(1), 72-78.
The authors apply Bai-Perron tests to identify multiple structural breaks in their monetary time series. This analysis helps them distinguish between different sources of instability across various time periods.
Modern Divisia Monetary Aggregate Studies
Serletis, A., & Gogas, P. (2014). Divisia monetary aggregates, the great ratios, and classical money demand functions. Journal of Money, Credit and Banking, 46(1), 229-241.
This recent paper provides empirical support for Divisia aggregates using similar cointegration methods to Chen & Valcarcel. Serletis and Gogas find stable money demand relationships using Divisia measures, which directly supports Chen & Valcarcel’s conclusions.
Belongia, M. T., & Ireland, P. N. (2019). The demand for Divisia money: Theory and evidence. Journal of Macroeconomics, 61, 103128.
This theoretical and empirical paper provides strong support for the user cost approach that Chen & Valcarcel advocate. Belongia and Ireland demonstrate both the theoretical superiority and empirical reliability of Divisia user costs over traditional interest rates.
Belongia, M. T., & Ireland, P. N. (2016). Money and output: Friedman and Schwartz revisited. Journal of Money, Credit and Banking, 48(6), 1223-1266.
This paper shows that including Divisia monetary aggregates in VAR models improves the identification of monetary policy shocks. Chen & Valcarcel’s work provides the money demand foundation that supports such improved monetary policy analysis.
Alternative Money Demand Specifications
Lucas, R. E., & Nicolini, J. P. (2015). On the stability of money demand. Journal of Monetary Economics, 73, 48-65.
Lucas and Nicolini propose alternative monetary aggregates (like MZM) to address instability issues, finding more stable relationships than traditional M1/M2. Chen & Valcarcel’s work suggests that Divisia aggregates provide an even more theoretically grounded solution to the same problem.
Teles, P., & Zhou, R. (2005). A stable money demand: Looking for the right monetary aggregate. Journal of Payment Systems Law, 1, 281.
This paper advocates switching between different simple-sum aggregates across time periods to maintain stability. Chen & Valcarcel’s approach offers a more systematic solution by using theoretically consistent Divisia measures throughout.
Monetary Policy and Central Banking
Bernanke, B., & Blinder, A. S. (1992). The federal funds rate and the transmission of monetary policy. American Economic Review, 82(4), 901-921.
This highly influential paper contributed to the Federal Reserve’s focus on interest rates rather than monetary aggregates by showing the superior information content of the federal funds rate. Chen & Valcarcel’s findings suggest this conclusion might need revision if Divisia aggregates were considered.
Christiano, L. J., Eichenbaum, M., & Evans, C. L. (1999). Monetary policy shocks: What have we learned and to what end? Handbook of Macroeconomics, 1, 65-148.
This comprehensive survey of monetary policy transmission largely ignores monetary aggregates due to their perceived instability. Chen & Valcarcel’s work provides evidence that could restore monetary quantities to central roles in policy analysis.
Financial Innovation and Banking
Judson, R., Schlusche, B., & Wong, V. (2014). Demand for M2 at the zero lower bound: The recent US experience.
This Federal Reserve study examines money demand during the zero lower bound period, finding continued instability in simple-sum measures. Chen & Valcarcel’s analysis of the same period using Divisia measures and user costs provides a contrasting perspective.
Anderson, R. G., Bordo, M., & Duca, J. V. (2017). Money and velocity during financial crises: From the great depression to the great recession. Journal of Economic Dynamics and Control, 81, 32-49.
This paper examines monetary aggregates during crisis periods, advocating for a return to quantity-theoretic approaches. Chen & Valcarcel’s stable Divisia relationships provide empirical support for such renewed attention to monetary quantities.
User Cost and Interest Rate Studies
Belongia, M. T. (2006). The neglected price dual of monetary quantity aggregates. In Money, Measurement and Computation, New York: Palgrave Macmillan.
This work emphasizes the theoretical importance of user costs as the true price of monetary services. Chen & Valcarcel’s empirical findings strongly support Belongia’s theoretical arguments about the superiority of user costs over market interest rates.
Mattson, R. S., & Valcarcel, V. J. (2016). Compression in monetary user costs in the aftermath of the financial crisis: Implications for the Divisia M4 monetary aggregate. Applied Economics Letters, 23(18), 1294-1300.
This paper by one of Chen & Valcarcel’s co-authors examines user cost behavior during the financial crisis. The current paper extends this analysis to show how user costs maintain their information content even when Treasury rates become uninformative.
International Evidence
Benati, L., Lucas, R. E., Nicolini, J. P., & Weber, W. (2016). International Evidence on Long Run Money Demand. National Bureau of Economic Research Working Paper.
This cross-country study finds mixed evidence on money demand stability using simple-sum aggregates. Chen & Valcarcel’s methodology could potentially be applied internationally to test whether Divisia measures show greater stability across countries.
Monetary Aggregation Data
Barnett, W. A., Liu, J., Mattson, R. S., & van den Noort, J. (2013). The new CFS Divisia monetary aggregates: Design, construction, and data sources. Open Economies Review, 24(1), 101-124.
This paper describes the construction of the Divisia monetary aggregates that Chen & Valcarcel use in their analysis. The availability of these high-quality, consistently constructed data series is crucial for their empirical work.
Business Cycle and Forecasting
Keating, J. W., Kelly, L. J., Smith, A. L., & Valcarcel, V. J. (2019). A model of monetary policy shocks for financial crises and normal conditions. Journal of Money, Credit and Banking, 51(1), 227-259.
This paper by Valcarcel and co-authors shows how including monetary aggregates improves the identification of policy shocks. Chen & Valcarcel’s money demand analysis provides the theoretical foundation for such improved monetary policy modeling.
Recent Methodological Advances
Bae, Y., Kakkar, V., & Ogaki, M. (2006). Money demand in Japan and nonlinear cointegration. Journal of Money, Credit and Banking, 38(6), 1659-1667.
This paper introduces the double-log functional form for money demand that Chen & Valcarcel employ alongside the traditional semi-log specification. The nonlinear specification proves particularly useful during zero lower bound periods.
Isakin, M., & Serletis, A. (2023). Divisia Monetary Aggregates with Unobserved Assets. Available at SSRN 4579531.
This recent work addresses the 2020 definitional changes in monetary aggregates that forced Chen & Valcarcel to end their sample in March 2020. Isakin and Serletis provide a methodology for extending Divisia analysis beyond this structural break.
Zhengyang (Robin) Chen
Assistant Professor in Economics
My research interests include Macroeconomics and Monetary Economics, Time Series Analysis and Financial Markets.