Monetary conditions index: Role of Exchange Rate
An important issue in the construction of aMCI pertains to the determination of the relative weight on the real exchange rate. The two parameters a1 and a2 that make up the relative weight are not observable and must therefore be estimated. Whichever relative weight appears in the MCI depends on the specification of the model chosen to estimate aggregate demand. Empirical studies have shown that the range (statistical confidence intervals) for the empirical estimates of the key parameters is excessivelywide and often includes zero as a possible estimate. Other issues pertain to the selection of interest rates and exchange rates: real versus nominal, short-term versus long(er)-term interest rates, trade-weighted versus bilateral exchange rates.
The usefulness of a MCI is also hampered by its rather narrow view of the monetary transmission mechanism. In essence, the conception of the original MCI rests on the assumption that the real exchange rate affects aggregate demand and that aggregate demand in turn affects the rate of inflation. Direct effects of the real exchange rate on the rate of inflation through import prices are thus ruled out. Yet in an open economy this direct exchange rate channel plays an important role in determining overall inflation.
The literature explaining the design and use of an MCI warns against mechanically adjusting the interest rate in the wake of a weaker or stronger exchange rate. Careful analysis of the circumstances that gave rise to the change in the exchange rate is warranted before a central bank contemplates a change in the policy instrument. Shocks that originate in the real sector of the economy and lead to changes in the real exchange rate call for a change in monetary conditions, whereas lack of credibility in the conduct of monetary policy or portfolio shocks, that is, shocks in financial sector of the economy, that lead to aweakening of the real exchange rate are to be countered by increases in the interest rate so as to leave monetary conditions unchanged.
It is conceivable that different constellations of the interest rate and the exchange rate could yield the same level of theMCI. In such a situation monetary conditions are the same and the policymakermay be tempted to choose a particularmix of the interest rate and the exchange rate. Yet the outcome for real economic activity and the rate of inflation will most certainly depend on the particular mix chosen, especially if time lags play an important role in the transmission process of monetary policy.
MCIswere still being published around theworld as of 2007, because they provide a simple gauge of monetary conditions in an economy. Although MCIs are of some use to financial markets and the general public as an information variable, they play only aminor role in the implementation ofmonetary policy at central banks.