Monetary conditions index
In
An MCI may also serve as a day-to-day operating target for the conduct of monetary policy, especially in small open economies. Central banks compute MCIs, with the Bank of Canada being the first to do so, beginning in the early 1990s.
The MCI begins with a simple model of the determinants of
Let aggregate demand take the following simple form:
Where:
- y = aggregate demand, logged;
- r = real interest rate, measured in percents, not decimal fractions;
- q = real exchange rate, defined as the natural logof an index number that is set to 1 in the base period (numbered 0 by convention);
- ν = stochastic error term assumed to capture all other influences on aggregate demand.
a1 and a2 are the respective real interest rate and real exchange rate elasticities of aggregate demand. Empirically, we expect both a1 and a2 to be negative, and 0 ≤ a1/a2 ≤ 1.
Let MCI0 be the (arbitrary) value of the MCI in the base year. The MCI is then defined as:
Hence MCIt is a weighted sum of the changes between periods 0 and t in the real interest and exchange rates. Only changes in the MCI, and not its numerical value, are meaningful, as is always the case with index numbers. Changes in the MCI reflect changes in monetary conditions between two points in time. A rise (fall) in the MCI means that monetary conditions have tightened (eased).
Because an MCI begins with a linear combination, infinitely many distinct pairs of interest rates, r, and exchange rates, q, yield the same value of the MCI. Hence r and q can move a great deal, with little or no effect on the value of the MCI. Nevertheless, the differing value of r and q consistent with a given value of MCI may have widely differing implications for
The real interest rate and real exchange rate require a measure of the price level, often calculated only quarterly and never more often than monthly. Hence calculating the MCI more often than monthly would not be meaningful. In practice, the MCI is calculated using the nominal exchange rate and a nominal short-run interest rate, for which data are readily available. This nominal variant of the MCI is very easy to compute in real time, even minute by minute, and assuming low and stable inflation, is not inconsistent with the underlying model of aggregate demand.
References
- Stevens, Glenn, 1998, "Pitfalls in the Use of Monetary Conditions Indexes," Reserve Bank of Australia Bulletin (August): 34–43.
- Ericsson, Neil R., et al. "Understanding a monetary conditions index." November 1997 meeting of the Canadian Macroeconomic Study Group in Toronto. 1997.