A Monetary Conditions Index (MCI) is an index number calculated from a linear combination of the short-run interest rate and the exchange rate. As a rule, the weights reflect the relative effects of the respective MCI component on aggregate demand (or in some cases on inflation).
Last update: 2 May 2013
Next update: 20 June 2013
The MCI is calculated as a weighted average of the real short-term interest rate and the real effective exchange rate relative to their value in a base period. In DG ECFIN’s MCI, the relative weights of the interest rate and the exchange rate component are 6:1. These weights reflect each variable’s relative impact on GDP after two years and are derived from simulations in the OECD’s Interlink model.
Simplicity and timeliness are the most attractive features of an MCI. However, there are significant difficulties related to their use and interpretation. The weights used for constructing MCIs are model-dependent and derived using a ceteris paribus approach.
Consequently, the weights are subject to estimation uncertainty, which may imply large confidence intervals for the parameters. In addition, different models can result in quite different MCI weights. Moreover, the appropriate relative weights may vary over time, while the parameters used in the calculations of the MCI are normally held constant.
When interpreting the MCI, one has to keep in mind that it cannot be used to assess the stance of monetary policy. The monetary policy stance should be assessed by means of the central bank’s policy instruments and the central bank’s objective. In the case of the euro, the interest rates are controlled by the ECB, while the exchange rate responds to many influences other than monetary policy decision. In line with the monetary policy strategy of the ECB, the appropriate level of interest rates depends on an overall assessment of all information which might be relevant for price developments.