Monetary conditions index: Explaining the MCI
In its simplest form an aggregate demand relation can be modeled as follows:
yt¼ a1rt a2et þnt
a1, a2 > 0
yt ¼aggregate demand,
rt ¼ real interest rate,
et ¼ real exchange rate (rise implies that domestic currency is appreciating, all other things being equal), and vt ¼other factors that influence aggregate demand.
The size of a1 and a2 reflect the relative effect of the real interest rate and exchange rate channel on aggregate demand. Both parameters are important ingredients in the construction of the MCI:
MCIt ¼(rt r0)þ a2 a1 (et e0)þ100
TheMCI at time t is aweighted sumof the change in the real rate of interest and the change in the real exchange rate relative to the base period. The interest rate is measured in percentage points while the exchange rate appears in index formwith 100 being its value in the base period. The selection of the base period is arbitrary. The weight on the real exchange rate is typically less than or equal to one.
According to the above specification, a one-point rise in the real interest rate at time t is associatedwith a one-point rise in the MCI. If the relative weight on the real exchange rate is one half, then a two-point rise in the real exchange rate also leads to a one-point increase in theMCI. It is important to keep inmind that the absolute level of the MCI is meaningless. Changes in the MCI reflect changing monetary conditions between two points in time. An increase (decrease) in the index indicates that monetary conditions have tightened (eased).