ESSAYS IN DIVISIA MONETARY AGGREGATION: APPLICATIONS TO THE GULF MONETARY UNION

In the aftermath of the 2007-08 financial crisis when short-term nominal interest rate reached zero, many central banks worldwide have adopted unconventional monetary policy tools such as quantitative easing where central banks inject money via purchases of long-term government bonds to stimulate their economies. Using the officially published simple-sum monetary aggregates to measure monetary service flows of the economy can be misleading since the simple-sum index ignores the liquidity characteristics of assets in monetary aggregates. Divisia indexes remove the investment motive and measure all other monetary services associated with economic liquidity, by allowing the weights of monetary assets to vary depending on their monetary services at the margin. This dissertation introduces key economic indicators for the Gulf states and discusses the main issues related to monetary policy and theory, aggregation theory and index number theory. It outlines the methods for constructing proper inflation and monetary indexes that are consistent with monetary theory and aggregation theory. Moreover, it provides guidelines for creating optimal monetary aggregation, as suggested by the originator of Divisia monetary aggregation, William A. Barnett. This dissertation reports on the first Divisia monetary aggregates for the complete GCC area and focuses on economic measurement. The second chapter builds monthly time-series of Divisia monetary aggregates for the Gulf area for the period of June 2004 to December 2011, using area-wide data. It also offers an "economic stability" indicator for the GCC area by analyzing the dynamics pertaining to certain variables such as the dual price aggregates, aggregate interest rates, and the Divisia aggregate user-cost growth rates. Our findings unfold the superiority of the Divisia indexes over the officially published simple-sum monetary aggregates in monitoring the business cycles. There is also direct evidence on higher economic harmonization between GCC countries--especially in terms of their financial markets and the monetary policy. Monetary policy often uses interest rate rules, when the economy is subject only to technology shocks. In that case, money is nevertheless relevant as an endogenous indicator [Woodford, M. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University Press]. Properly weighted monetary aggregates provide critical information to policy makers regarding inside liquidity created by financial intermediaries. In addition, policy rules should include money as well as interest rates, when the economy is subject to monetary shocks as well as technology shocks. The data show narrow aggregates growing while broad aggregates collapsed following the financial crises. This information clearly signals problems with the financial system's ability to create liquidity during the crises. The third chapter investigates the feasibility of forming a common currency area over the Gulf states by testing the weak separability of the monetary aggregates within and then over the GCC countries. Our findings indicate the weak separability of the broad monetary aggregates for the individual GCC countries from private consumption and hence the existence of broad monetary aggregates. The narrow monetary aggregates do exist for the GCC countries except for Qatar where the demand deposits (which offer positive interest rates) cannot be grouped with currency. Our weak separability tests on the Gulf area confirm the existence of the broad monetary aggregate. However, a narrow monetary aggregate for the entire GCC area does not exist and hence the GCC countries cannot form a common currency area. We find that if Oman is excluded from the monetary union, being a non-oil producing country and hence heterogeneous with respect to the remaining GCC countries, a common currency area is feasible. Using our admissible groups of GCC monetary assets, we construct Divisia monetary aggregates. Our findings suggest the superiority of Divisia indexes over their counterpart simple-sum monetary aggregates in resembling the business cycle patterns where Divisia monetary indexes are low prior to the recent financial crisis and higher afterwards indicating their ability to signal financial turmoil. Finally, the fourth chapter provides core inflation indicators for the complete GCC area along with alternative inflation measurements. It constructs core inflation indicators for the GCC countries and then recursively builds a single core inflation indicator for the Gulf area for the period of June 2004 to December 2011. This chapter proposes core inflation indicators for the GCC area based upon two alternative monetary aggregates: Divisia monetary aggregates and simple-sum monetary aggregates. Using the Generalized Dynamic Factor Model (GDFM), the core inflation indicators for the Gulf area were obtained by extracting the long-term common components of inflation while disregarding the short-term components--thereby eliminating idiosyncratic shocks and transitory noise from our inflation measures. Lastly, this chapter shows that the predictive performance of the Divisia monetary aggregates dominates their simple-sum counterparts for inflation forecasts in the Gulf area