The money supply can be broadly defined as consisting of currency and deposits. While currency forms but a small portion of the total money supply, it can be a crucial determinant of spending behaviour and subsequently economic activity. The ability of the money supply to predict an up- or downswing in economic activity, as measured by a positive or negative output gap, is evaluated over a sample period 1980 – 2012. Two models are estimated, one using only the currency component and a second using the total money supply (M3).
Estimates of the output gap are an important component of policy-makers’ toolkits. Both the theory underlying monetary policy analysis and the empirical models employed by central banks suggest that the output gap is a key variable explaining inflation. In this view, the estimate of the output gap provides not only an indication of how well the economy is operating relative to its potential, it also signals whether inflation is likely to increase or decrease in the future. The reliability of estimates of the output gap is therefore extremely important for policy making.