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.
|
