Money Is What Money Predicts: The M* Model of the Price Level

Gregory D. Hess
Charles S. Morris
June 1995 RWP 95-05
Research Division
Federal Reserve Bank of Kansas City

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.

Gregory Hess is an assistant professor in the Department of Economics at the University of Kansas and a Visiting Scholar at the Federal Reserve Bank of Kansas City. Charles Morris is an assistant vice president and economist at the Federal Reserve Bank of Kansas City. The authors would like to thank Todd Clark, Andrew Filardo, and seminar participants at the Federal Reserve Bank of Kansas City, the Board of Governors of the Federal Reserve System, the Federal Reserve's System Committee on Macroeconomics, and Wellesley College for helpful discussions, and John Duca, Allan Meltzer and Richard Porter for detailed comments. Stacy Bear, a research associate at the bank, and Ken Heinecke, a former research associate, provided research assistance. The views expressed herein are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or of the Federal Reserve System.

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