This paper studies the dynamic interactions between the money supply and the shape of the yield curve in the context of a regime-switching latent factor model. Estimates show that the money supply has important implications for the level, slope, and curvature of the yield curve. Moreover, the Divisia aggregates can provide more information than simple-sum aggregates based on parameter estimates and impulse response functions in understanding the dynamics of the yield curve. The favored broad Divisia aggregate could especially be associated with changes in the yield curve’s level, slope, and curvature over the business cycle. Therefore, this paper highlights the important role of Divisia aggregates in the linkage between financial markets and monetary policy.

We follow Belongia and Ireland (2021) and investigate the role that the Center for Financial Stability credit card-augmented Divisia monetary aggregates could play in monetary policy and business cycle analysis. We use Bayesian methods to estimate a structural VAR under priors that reflect Keynesian channels of monetary transmission, but produce posterior distributions for the structural parameters consistent with classical channels. We also find that valuable information is contained in the credit-augmented Divisia monetary aggregates and that they perform even better than the conventional Divisia aggregates, in terms of highlighting the role of the money supply in aggregate demand.

We estimate elasticities of substitution between components of the Bank of England’s household-sector UK Divisia monetary aggregate using quarterly data from 1999 to 2019, encompassing the period surrounding the global financial crisis. The demand system includes interest-bearing sight and time deposits at monetary financial institutions as components, since deposit data for banks (excluding mutuals) and for mutuals are no longer published separately. We find that the elasticities of substitution that relate to changes in the user cost of noninterest-bearing monetary assets imply inelastic substitution over all or almost all of the sample and, consequently, a conventional monetary aggregate would be a highly misleading economic indicator relative to a Divisia monetary aggregate.