Monetary conditions index
Encyclopedia
In macroeconomics
, a Monetary Conditions Index (MCI) is an index number calculated from a linear combination
of a small number of economy-wide financial variables deemed relevant for monetary policy
. These variables always include a short-run interest rate
and an exchange rate
.
An MCI may also serve as a day-to-day operating target for the conduct of monetary policy, especially in small open economies
. Central bank
s 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 aggregate demand
in an open economy
, which include variables such as the real exchange rate as well as the real interest rate
. Moreover, monetary policy is assumed to have a significant effect on these variables, especially in the short run. Hence a linear combination of these variables can measure the effect of monetary policy on aggregate demand. Since the MCI is a function of the real exchange rate, the MCI is influenced by events such as terms of trade
shocks, and changes in business and consumer confidence
, which do not necessarily affect interest rates.
Let aggregate demand take the following simple form:
Where:
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 real output
and the inflation rate
, especially if the time lags in the transmission of monetary policy
are material. Since a1 and a2 are expected to have the same sign, r and q may move in opposite directions with little or no change in the MCI. Hence an MCI that changes little after an announced change in monetary policy is evidence that financial markets view the policy change as lacking credibility.
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
.
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
, a Monetary Conditions Index (MCI) is an index number calculated from a linear combination
Linear combination
In mathematics, a linear combination is an expression constructed from a set of terms by multiplying each term by a constant and adding the results...
of a small number of economy-wide financial variables deemed relevant for monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
. These variables always include a short-run interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
and an exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
.
An MCI may also serve as a day-to-day operating target for the conduct of monetary policy, especially in small open economies
Open economy
An open economy is an economy in which there are economic activities between domestic community and outside, e.g. people, including businesses, can trade in goods and services with other people and businesses in the international community, and flow of funds as investment across the border...
. Central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
s compute MCIs, with the Bank of Canada
Bank of Canada
The Bank of Canada is Canada's central bank and "lender of last resort". The Bank was created by an Act of Parliament on July 3, 1934 as a privately owned corporation. In 1938, the Bank became a Crown corporation belonging to the Government of Canada...
being the first to do so, beginning in the early 1990s.
The MCI begins with a simple model of the determinants of aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
in an open economy
Open economy
An open economy is an economy in which there are economic activities between domestic community and outside, e.g. people, including businesses, can trade in goods and services with other people and businesses in the international community, and flow of funds as investment across the border...
, which include variables such as the real exchange rate as well as the real interest rate
Real interest rate
The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
. Moreover, monetary policy is assumed to have a significant effect on these variables, especially in the short run. Hence a linear combination of these variables can measure the effect of monetary policy on aggregate demand. Since the MCI is a function of the real exchange rate, the MCI is influenced by events such as terms of trade
Terms of trade
In international economics and international trade, terms of trade or TOT is /. In layman's terms it means what quantity of imports can be purchased through the sale of a fixed quantity of exports...
shocks, and changes in business and consumer confidence
Consumer confidence
Consumer confidence is an economic indicator which measures the degree of optimism that consumers feel about the overall state of the economy and their personal financial situation. How confident people feel about stability of their incomes determines their spending activity and therefore serves as...
, which do not necessarily affect interest rates.
Let aggregate demand take the following simple form:
Where:
- y = Aggregate demandAggregate demandIn macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
, logged; - r = Real interest rateReal interest rateThe "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
, measured in percents, not decimal fractions; - q = Real exchange rate, defined as the foreign currency price of a unit of domestic currency. A rise in q means that the domestic currencyCurrencyIn economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
appreciates. q is the natural log of an index number that is set to 1 in the base period (numbered 0 by convention); - ν = Stochastic error termRandom variableIn probability and statistics, a random variable or stochastic variable is, roughly speaking, a variable whose value results from a measurement on some type of random process. Formally, it is a function from a probability space, typically to the real numbers, which is measurable functionmeasurable...
assumed to capture all other influences on aggregate demand.
a1 and a2 are the respective real interest rate
Real interest rate
The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
and real exchange rate elasticities
Elasticity (economics)
In economics, elasticity is the measurement of how changing one economic variable affects others. For example:* "If I lower the price of my product, how much more will I sell?"* "If I raise the price, how much less will I sell?"...
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 real output
Real GDP
Real Gross Domestic Product is a macroeconomic measure of the value of output economy adjusted for price changes . The adjustment transforms the money-value measure, called nominal GDP, into an index for quantity of total output...
and the inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...
, especially if the time lags in the transmission of monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
are material. Since a1 and a2 are expected to have the same sign, r and q may move in opposite directions with little or no change in the MCI. Hence an MCI that changes little after an announced change in monetary policy is evidence that financial markets view the policy change as lacking credibility.
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
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
and a nominal short run interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
, 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
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
, is not inconsistent with the underlying model of aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
.