Working Paper

Hazards in implementing a monetary conditions index

Abstract: Some recent studies have suggested constructing a Monetary Conditions Index (or MCI) to serve as an indicator of monetary policy stance. The central banks of Canada, Sweden, and Norway all construct an MCI and (to varying degrees) use it in conducting monetary policy. Empirically, an MCI is calculated as the weighted sum of changes in a short-term interest rate and the exchange rate relative to values in a baseline year. The weights aim to reflect these variables' effects on longer-term focuses of policy -- economic activity and inflation. This paper derives analytical and empirical properties of MCIs in an attempt to ascertain their usefulness in monetary policy. ; An MCI assumes an underlying model relating economic activity and inflation to the variables in the MCI. Several issues arise for that model, including its empirical constancy, cointegration, exogeneity, dynamics, and potential omitted variables. Because of its structure, the model is unlikely to be constant or to have strongly exogenous variables; and we show that constancy and exogeneity are critical for the usefulness of an MCI. Empirical analyses of Canadian, Swedish, and Norwegian MCIs confirm such difficulties. Thus, the value of an MCI for conduct of economic policy is in doubt.

Keywords: Monetary policy;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 1996

Number: 568