Is money demand really unstable? Evidence from Divisia monetary aggregates

We revisit the issue of stable demand for money, using quarterly data for the European Monetary Union, India, Israel, Poland, the UK, and the US. We investigate the long-term relationship between real money balances, real output, interest rate, and real effective exchange rate, using a modern version of the linear time-series macroeconometric model, that had previously cast doubt on money demand stability. Evidence of stable demand for money is found. Broad money, in general, captures a more stable demand for money than narrow money. The stability results are especially strong, when broad Divisia money is used instead of its simple sum counterpart. Central banks can achieve their long-run “price stability” goal more effectively by using broad Divisia money growth as a key information variable that acts as a long-term check on short-term interest rate decisions.