Rebuilding the money measure: Constructing divisa monetary aggregates for Iceland

Abstract

This thesis constructs Divisia monetary aggregates for Iceland and evaluates their performance compared to traditional simple-sum measures. Motivated by international evidence showing that Divisia aggregates better capture monetary services by accounting for differences in liquidity and opportunity cost, this study applies Barnett’s user cost framework to Icelandic monetary data from 2009 to 2024. The resulting Divisia D1, D2, and D3 indices are examined against the business cycle and tested in forecasting models. The analysis finds that Divisia aggregates are smoother and more stable than simple-sum measures, suggesting they may better filter out noise. While Divisia D1 shows a contemporaneous correlation with GDP, neither Divisia nor simple-sum aggregates demonstrate strong predictive power in VAR models. Additionally, certain structural features of the Icelandic financial system introduce limitations that affect the performance of the index. Although Divisia did not outperform simple-sum aggregates in GDP forecasting, it presents a promising foundation for real-time indicators and now-casting applications in Iceland. These findings contribute to the ongoing discussion about improving monetary measurement in small, open economies with unique financial structures. Keywords: Divisia, monetary aggregates, simple-sum, user cost, monetary policy, Iceland.