Home » Analysis and Tools » Monetary conditions index: MCI in Practice

Published: декабря 3, 2012

Monetary conditions index: MCI in Practice

Monetary conditions index

Monetary conditions index: Explaining the MCI

Monetary conditions index: Role of Exchange Rate

MCIs figured prominently in monetary policy deliberations at the Bank of Canada and the Reserve Bank of New Zealand in the 1990s. The rationale for constructing these indexes was grounded in the assumption that a central bank can wield considerable control overmonetary conditions and that in a small open economy changes in monetary conditions are reflected mainly by changes in the interest rate and the exchange rate, which in turn affect aggregate demand. The level of aggregate demand is the most important factor in determining the rate of inflation. With price stability being an important, if not the overriding, goal of monetary policy, it was incumbent on the central bank to establish desirable monetary conditions that are consistent with price stability. In practice, the central bank prepared a path for the monetary conditions index thatwas compatiblewith inflation forecasts. In the interval between inflation forecasts, the bank monitored the actualMCI to see if it diverged from its desired path or range. In the event that marked differences appeared, the central bank would adjust the interest rate to correct the course of the actual MCI. If evidence emerged for a change in expected inflation, the central bank adjusted the path of the MCI to be compatible with the inflation objective. Given the close attention both central banks paid to the MCI in the day-to-day operation of monetary policy, it seems clear that theMCI served as a shortterm operating target.

For other central banks, MCIs have figured less prominently as indicator variables next to the term spread or monetary and credit aggregates. The InternationalMonetary Fund and theOrganisation for Economic Co-operation and Development, as well as commercial banks, have also published monetary conditions indexes for various countries. These MCIs serve primarily as information variables: the banks use the actualMCI to assess currentmonetary conditions and their likely effect on inflation and real economic activity.

Beginning with the new millennium, the prominence of MCIs has waned considerably. Central banks, international organizations, and commercial banks still calculated and monitored MCIs as of 2007, but they played a minor role in monetary policy deliberations. The virtual demise of the MCI is due to several factors, some of which are related to its construction and underlying view of the transmission mechanism. Interpreting observed changes in the index can also be problematic as they depend on one’s view of how the economy works.