Divisia monetary aggregates, monetary policy and business cycle analysis

Abstract The paper builds a parsimonious US business cycle SVARMA model, establishing identification conditions for independent monetary shocks. The SVARMA model, utilizing Divisia M3 and Divisia M4, is compared to the simple sum M2. The monetary rule with Divisia M3 yields theoretically consistent results marked by the absence of the usual price and liquidity puzzles. As the Federal Reserve (Fed) took a more hawkish approach to curb inflation, significant increases in US interest rates and declines in monetary aggregates were largely influenced by the Fed’s reaction function, which incorporates the Divisia M3 monetary rule. Findings emphasize the monetary impact on the business cycle, highlighting the significance of Divisia monetary aggregates. Historical and variance decompositions reveal diverse, dynamic effects of monetary shocks on macroeconomic variables. The SVARMA model with Divisia M3 and M4 demonstrates superior performance over simple sum M2 in capturing the time path of monetary shocks.