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Properties of the monetary conditions index

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  • Grande, Giuseppe

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 signalling 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.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 23515.

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Date of creation: Dec 1997
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Handle: RePEc:pra:mprapa:23515

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

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References

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  1. Maurice Obstfeld & Kenneth Rogoff, 1983. "Exchange Rate Dynamics With Sluggish Prices Under Alternative Price-Adjustment Rules," NBER Working Papers 1173, National Bureau of Economic Research, Inc.
  2. Fuhrer, Jeff & Moore, George, 1992. "Monetary policy rules and the indicator properties of asset prices," Journal of Monetary Economics, Elsevier, Elsevier, vol. 29(2), pages 303-336, April.
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  11. David Longworth & Brian O´Reilly, 2002. "The Monetary Policy Transmission Mechanism and Policy Rules in Canada," Central Banking, Analysis, and Economic Policies Book Series, Central Bank of Chile, in: Norman Loayza & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series (ed.), Monetary Policy: Rules and Transmission Mechanisms, edition 1, volume 4, chapter 13, pages 357-392 Central Bank of Chile.
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  13. Eika, Kari H & Ericsson, Neil R & Nymoen, Ragnar, 1996. "Hazards in Implementing a Monetary Conditions Index," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 58(4), pages 765-90, November.
  14. Michael Woodford, 1994. "Nonstandard Indicators for Monetary Policy: Can Their Usefulness Be Judged from Forecasting Regressions?," NBER Chapters, in: Monetary Policy, pages 95-115 National Bureau of Economic Research, Inc.
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Cited by:
  1. Paolo Chiades & Leonardo Gambacorta, 2004. "The Bernanke and Blinder Model in an Open Economy: The Italian Case," German Economic Review, Verein für Socialpolitik, Verein für Socialpolitik, vol. 5(1), pages 1-34, 02.
  2. Andrzej Toroj, 2008. "Estimation of weights for the Monetary Conditions Index in Poland," Working Papers, Department of Applied Econometrics, Warsaw School of Economics 27, Department of Applied Econometrics, Warsaw School of Economics.
  3. Peeters, Marga, 1999. "Measuring monetary conditions in Europe: Use and limitations of the monetary conditions index," MPRA Paper 23534, University Library of Munich, Germany.

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