Properties of the Monetary Conditions Index

Abstract:     
In recent years increasing use has been made in monetary policy analysis of the so-called Monetary Conditions Index (MCI). The index is defined as a linear combination of changes in a short-term real interest rate and in the real effective exchange rate, whose coefficients are equal to the estimated effects of the two financial variables on real aggregate demand or, alternatively, on a price index. The MCI is usually regarded as a measure of the degree of tightness of monetary policy in an open economy. In this paper the properties of the index and its possible uses in monetary policy are investigated by means of a macroeconomic model of the Mundell-Fleming-Dornbusch type; the reaction of the index to different kinds of aggregate shock is considered. Two possible meanings of the index are discussed: as a measure of the stance of monetary policy in an open economy and as an inflation indicator. It is shown that the index can be misleading in both cases. The MCI is ineffective in signaling changes in the stance of monetary policy in the cases of a financial shock and an exchange rate shock and it may also be misleading in the case of a supply shock. As an inflation indicator the index is also subject to some drawbacks in the case of real shocks. The MCI is to be properly interpreted as a summary measure of the inflationary pressures stemming from the short term real interest rate and the real exchange rate. An MCI constructed for Italy turns out to have been affected in recent years by the wide fluctuations of the lira exchange rate, which were mainly due to shocks originating in the financial and foreign exchange markets.

Number of Pages in PDF File: 56

Keywords: monetary conditions, monetary policy stance, monetary policy indicators, information content, transmission mechanism, Italy

JEL Classification: E52, E58, E44, G14

working papers series