Currency equivalent monetary aggregates as leading indicators of inflation

This study examines whether the Currency Equivalent (CE) Monetary Aggregates proposed by Hutt (1963) and Rotemberg et al. (1995) can perform better in predicting inflation as compared to their simple sum counterparts. The components of four official measures of monetary constructs - M1, M2, M3 and L1 - are used to construct monthly CE monetary aggregates for the period from April 1993 to June 2009. The empirical evidence indicates that the growth rate of CE aggregates has an edge over their sum counterparts in predicting inflation. Moreover, the predictive power of the growth rates of CE aggregates improves as the level of aggregation increases. These evidences suggest that observing the movements in the growth rates of weighted monetary aggregates can be a better option within the “multiple indicator approach” which is being currently practiced by the Reserve Bank of India.

Research Highlights► The study constructs CE aggregates for India. ► Examines whether CE aggregates performs better as leading indicators of inflation. ► The growth rates of CE aggregates are better predictor of inflation. ► The predictive power of CE aggregates improves as the level of aggregation increases.