What is the Monetary Conditions Index (MCI)
The monetary conditions index (MCI) uses the short-term interest rate and the exchange rate of an economy’s national currency to gauge the relative ease or tightness of monetary conditions. The measure is typically used to help central banks craft monetary policy.
The monetary conditions index (MCI) has become a benchmark for use around the world.
BREAKING DOWN Monetary Conditions Index (MCI)
The Bank of Canada first developed the monetary conditions index in the early 1990s as a way of investigating the relationships between interest rates in Canada, the relative trading exchange rate of Canadian currency, and Canada’s economy as a whole. The bank provides data for both the MCI and its components on a monthly basis.
To calculate the monetary conditions index (MCI) the central banks of the nation will typically select a base period and chart the weighted average of interest rate changes and exchange rate changes against the actual values of those variables. In theory, this calculation allows central banks to monitor the effect of short-term monetary policy by linking changes in interest rates set by central banks with changes to exchange rates influenced by the open foreign exchange market.
The MCI calculation uses the change in the 90-day commercial paper rate since 1987, then adds a portion of the movement in the exchange rate of the Canadian dollar (CAD). This exchange rate measures the CAD to the C-6 exchange rate. The C-6 averages the currencies of six of Canada's major trading partners, the United States, EU, Japan, United Kingdom, Switzerland, and Sweden.
Growing Use of MCI
The use of the relatively simple calculation behind the MCI has grown. Now, many other central banks use it as a benchmark and a tool to help guide monetary policy. Not only do central banks around the globe use the MCI, but organizations such as the International Monetary Fund (IMF) and Organization for Economic Cooperation and Development (OECD) use the calculation for a variety of economies.
While the components of the index remain broadly the same, different organizations will apply various weight to the elements of the equation. Using varying weights will reflect real conditions in a given economy as accurately as possible. For example, the Directorate-General for Economic and Financial Affairs of the European Commission currently uses a 6:1 weighting on the interest and exchange rates component of the calculation respectively, based upon previous economic results.
In some cases, external factors may imply a need for changes to the weighting of variables in the MCI calculation. However, central banks will usually use constant parameters. Also, since the MCI offers a view of the relative ease or tightness of an economy over time, the simplicity and transparency of the model may limit its use as the only primary measure of the effectiveness of monetary policy.