Monetary conditions index

Monetary conditions index: Explaining the MCI

Monetary conditions index: MCI in Practice

Monetary conditions index: Role of Exchange Rate

A monetary conditions index (MCI) is a simple device that combines movements in different financial variables, notably the interest rate and the exchange rate, into a single number. It serves as an easy-tounderstand reference or information variable to financial markets and the general public at a point in time relative to some point in the past. In addition, a MCI can function as a short-termoperating target in the conduct of monetary policy in small open economies.

The Bank of Canada pioneered the construction of a MCI in the early 1990s. The original MCI consisted of a weighted average of the real short-term interest rate and the real exchange rate, the respective nominal rate adjusted for inflation and the price of domestic relative to foreign goods. In practice, however, the MCI has been stated in terms of the nominal short-term interest rate and the nominal exchange rate, two of the most readily observable financial variables in the economy.

The basic idea behind the MCI is that in an open economy, both the real interest rate and the real exchange rate help determine aggregate demand. They can be combined to produce a simple gauge that measures the influence of both variables on aggregate demand. This indicator captures changes in the stance of monetary policy and the associated effects on the exchange rate. In addition, it records changes in the exchange rate that are not accompanied by changes in the interest rate, such as terms of trade shocks or loss of confidence. Finally, it registers movements of the interest rate and exchange rate in opposite directions in situations where, for instance, an announced policy change lacks credibility.

See also capitalmobility; exchange rate regimes; inflation targeting; interest parity conditions; monetary policy rules; money supply; Mundell-Fleming model; real exchange rate; Swan diagram

FURTHER READING

• Deutsche Bundesbank. 1999. ‘‘Taylor Interest Rate and Monetary Conditions Index.’’ Monthly Report (April): 47 63.Acritical assessment of the usefulness ofMCIs in the conduct of monetary policy. 
• Freedman, Charles. 1995. ‘‘The Role of Monetary Condi tions and the Monetary Conditions Index in the Con duct of Policy.’’ Bank of Canada Review (autumn): 53 59. An early contribution by a central banker that ex plains the rationale for constructing MCIs. 
• Guender, Alfred V. 2005. ‘‘On Optimal Monetary Policy Rules and the Construction of MCIs in the Open Eco nomy.’’ Open Economies Review 16: 189 207. This the oretical essay shows that standardMCIs are misspecified if a real exchange rate channel exists in the Phillips curve. 
• Reserve Bank of New Zealand, Economics Department. 1996. ‘‘Summary Indicators of Monetary Conditions.’’ Reserve Bank (of New Zealand) Bulletin 59 (3): 223 28. Offers the Reserve Bank of New Zealand’s perspective on the usefulness ofMCIs. 
• Stevens, Glenn. 1998. ‘‘Pitfalls in the Use of Monetary Conditions Indexes.’’ Reserve Bank (of Australia) Bulletin (August): 34 43. A cogent summary of the reasons why central banks should exercise caution in basing the conduct of monetary policy onMCIs.

ALFRED V. GUENDER