What Is the Monetary Conditions Index (MCI)?
The Bank of Canada developed the monetary conditions index (MCI) as a policy guide for a central bank in a small open economy. It was intended to measure how monetary policy actions affect the economy through interest rates and the exchange rate. The MCI has become a benchmark for use around the world.
- The monetary conditions index (MCI) uses a nation's short-term interest rates and exchange rates to measure the ease or tightness of monetary conditions.
- The MCI was developed by the Bank of Canada.
- The U.S. uses a National Financial Conditions Index (NFCI), and the Bank of England uses a Monetary and Financial Conditions Index (MFCI), both more elaborate than the MCI.
Understanding the Monetary Conditions Index (MCI)
The Bank of Canada developed the monetary conditions index to study the relationships between interest rates in Canada, the relative trading exchange rate of Canadian currency, and Canada’s economy. The bank provides data for both the MCI and its components monthly.
To calculate the monetary conditions index (MCI), central banks select a base period and chart the weighted average of interest rate changes and exchange rate changes against the actual values of those variables. This calculation allows nations 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.
Interest rates and exchange rates affect the Monetary Conditions Index.
Calculating the MCI
In 1987, the MCI calculation used the change in the 90-day commercial paper rate, adding a percentage of movement in the exchange rate of the Canadian dollar (CAD). This exchange rate measured the CAD to the C-6 exchange rate. The C-6 averaged the currencies of six of Canada's trading partners: the United States, Europe, Japan, the United Kingdom, Switzerland, and Sweden.
The Canadian-dollar effective exchange rate index (CERI) replaced the C-6 index in 2006 and was retired in 2018 for the nominal Canadian effective exchange rate (CEER). The CEER captures 17 currencies, including those of the U.S., Japan, the U.K., Switzerland, Australia, and Sweden. The targeted countries include those that account for at least 0.5% of Canadian non-oil exports and Canadian non-oil imports.
MCI vs. Other Indexes
Many central banks use the MCI as a benchmark. The International Monetary Fund (IMF) and the Organization for Economic Co-operation and Development (OECD) use the measurement for a variety of economies.
External factors may affect the weighting of variables in the MCI calculation. However, central banks will usually use constant parameters.
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 MCI calculation based on previous economic results.The MCI is a starting point for central banks, but many nations have established alternate and more elaborate measures of financial conditions.
The Federal Reserve of the United States uses the National Financial Conditions Index (NFCI), which provides a complete weekly update on U.S. financial conditions in money markets, debt and equity markets, and banking systems.The Bank of England uses its Monetary and Financial Conditions Index (MFCI) to capture the relationship between asset prices, credit variables, and the U.K. economy.
Can MCI Be Used to Assess a Nation's Monetary Policy?
The MCI cannot accurately assess a nation's monetary policy. While interest rates may be controlled by a central bank, the exchange rate responds to many influences other than monetary policy decisions.
What Are the Limitations of Using the Monetary Conditions Index?
The Monetary Conditions Index (MCI) is often defined as a measure of changes in
the degree of tightness of monetary policy, however, other factors may affect
changes in monetary conditions, such as policy decisions whether monetary or fiscal, and external shocks to a nation's economy.
What Variables Are Used to Calculated the MCI?
The MCI is an index calculated from a linear combination of two financial variables relevant to monetary policy. These variables include a short-run interest rate and an exchange rate.
The Bottom Line
The Monetary Conditions Index (MCI) uses a nation's short-term interest rates and exchange rates to measure the tightness of monetary conditions in the economy. The MCI was developed by the Bank of Canada and is used by central banks and international organizations. The Federal Reserve of the United States and the Bank of England use an expanded index to analyze financial conditions in the nations.