Financial innovation and Divisia monetary indices in Taiwan: a neural network approach

In this paper a weigh ted index measure of money using the ‘Divisia’ formulation is constructed for the Taiwan economy and its in ation forecasting potential is compared with that of it s traditional simple sum counterpar t . This research extends an earlier s tudy by Gazely and Binner by examining the theory that rapid Ž nancial innovation, par ticularly during the Ž nancial liberalization of the 1980s , has been responsible for the poor performance of conventional simple sum monetary aggregates . The Divisia index is ad justed in two ways to allow for the major Ž nancial innovations that Taiwan has experienced since the 1970s . The technique of neural networks is used to allow a completely  exib le mapping of the variables and a greater variety of functional form than is currently achievable using conventional econometric techniques . Results suggest that superior tracking of in ation is possible for networks that employ a Divisia M2 measure of money that has been ad justed to incorporate a learning mechanism to allow individuals to gradually alter their percep tions of the increased productivity of money. Divisia measures of money appear to offer advantages over their simple sum counterpar ts as macroeconomic indicators .