Design flaws in the construction of monetary conditions indices? A cautionary note

Abstract

Monetary conditions indices featured prominently as instrument variables or operating targets, particularly in the inflation‐targeting countries during the 1990s. In this paper, we show that conventional monetary conditions indices are potentially mis‐specified. Under a regime of strict inflation targeting, conventional MCIs are unreliable indicator variables or operating targets if there is a direct exchange rate effect on the rate of inflation in the Phillips Curve. We also point to the limitations of a standard MCI under strict inflation targeting. The policymaker can circumvent these limitations by redefining the inflation target. Nevertheless, from a general perspective the usefulness of MCIs in the conduct of monetary policy is doubtful in view of their model‐specific nature.

Keywords::

• Monetary Conditions Index (MCI)
• Strict Inflation‐Targeting
• Direct Exchange Rate Channel
• Misspecification

Notes

Alfred V. Guender and Troy D. Matheson‐ Department of Economics, University of Canterbury, Private Bag 4800, Christchurch, New Zealand E‐mail: [email protected] and E‐mail: [email protected]

We thank Alex Cukierman, Richard Froyen, and David Mayes for helpful discussions on the subject. We also appreciate the detailed comments by the referee. All errors are the sole responsibility of the authors.