Divisia Monetary Aggregates for Developing Economies: Some Theory

Asset market development is characterized by reducing market imperfections that generate costs incurred from participating in the financial system. In developing economies where financial markets are nascent, these costs are likely to be binding. This limits the typical economic agent's ability to fully access asset market, inducing partial access. In this note, we embed financial market imperfections into the Divisia aggregate-theoretic literature and illustrate their relevance in the derivation of user cost of money and consequently, Divisia monetary aggregates. Asset market imperfections are introduced through endogenous portfolio adjustment costs that proxy for, among other things, informational, transactional, liquidity, and portfolio management costs. The presence of adjustment costs induce additional costs that alter the standard user cost of money. We show that the user cost that arises from our model can be practically implemented in the construction of Divisia aggregates as in the standard Barnett (1978) user cost.