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Monetary Conditions Index for Kenya: Computation of the MCI

Toroj used four empirical strategies (IS and Phillips curve, VAR model and small structural system of equations) to evaluate relative importance of the real interest rate and the real exchange rate in determining the output gap as a basis of computing the monetary conditions index (MCI). The weights for the real interest rate varied from 0.279 to 0.669, whereby most of the methods indicate a bigger role for the real interest rate. A higher weight attributed to the real interest rate in most outcomes could suggest a risk of a macroeconomic overheating or overcooling in the case of a cyclical divergence between Poland and the rest of EMU in a currency union. The research proposed that endogenous effects of monetary union membership could change the way that macroeconomic mechanisms work, so that real exchange rate channel is widely considered to be at work in the long run.
Kodra used ordinary least squares estimation for quarterly data between 1998 and 2008 for Albania to assess the relative weights of the real interest rates and the real exchange rate in the MCI. This study found a weight of 3.8 for the exchange rate meaning that the effect of an appreciation of the real exchange rate by 3.8 percentage points could be neutralized by one percentage point increase in the real interest rate. The interest rate here had more effect as expected over the exchange rate. However, this study found interest rates to have been losing ground in their impact on financial conditions overtime.
All the variables are expressed in logarithm form apart from the interest rate and by definition all series are in real terms. The parameters a and b represent the coefficients for interest rate and the exchange rate in the demand equation, which are used to derive the weights of the MCI.
The size of a and b reflect the relative effect of the real interest rate and the real exchange rate on aggregate demand. The MCI will be computed using quarterly data between 2000 and 2011. Selection of the base is arbitrary. An increase in the MCI reflects tightening while a decrease in the MCI reflects easing of the monetary conditions. Tightening is done through an increase in local interest rates which induces capital inflows and consequently leads to an appreciation of the domestic exchange rate. Exchange rate appreciation makes the current account worse off and hence tightening the monetary conditions serves to reduce aggregate demand and vice versa.

This post was written by , posted on January 29, 2014 Wednesday at 4:52 pm