Measurement Error in Monetary Aggregates: A Markov Switching Factor Approach

This paper compares the different dynamics of simple sum monetary aggregates and the Divisia indexes over time, over the business cycle, and across high and low inflation and interest rate phases. Although the traditional comparison of the series may suggest that they share similar dynamics, there are important differences during certain times and around turning points that can not be evaluated by their average behavior. We use a factor model with regime switching that offers several ways in which these differences can be analyzed. The model separates out the common movements underlying the monetary aggregate indexes, summarized in the dynamic factor, from individual variations in each one series, captured by the idiosyncratic terms. The idiosyncratic terms and the measurement errors represent exactly where the monetary indexes differ. We find several new results. In general, the idiosyncratic terms for both the simple sum aggregates and the Divisia indexes display a business cycle pattern, especially since 1980. They generally rise around the end of high interest rate phases – a couple of quarters before the beginning of recessions – and fall during recessions to subsequently converge to their average in the beginning of expansions. We also find that the major differences between the simple sum aggregates and Divisia indexes occur around the beginning and end of economic recessions, and during some high interest rate phases