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Monetary Conditions Index for Kenya: Empirical Studies

Monetary Conditions Index for Kenya: Empirical StudiesIn conducting monetary policy, central banks try to marry the short term objective of reacting efficiently and flexibly to economic shocks and the long-term objective of securing low and stable inflation. According to Mahadeva and Stern monetary policy is simple where there is a single objective, a single instrument and policy makers had available a model that accurately comprehensively and transparently models the transmission mechanism of money. In a regime of floating exchange rates and mobile capital, both interest rates and the exchange rates are important components in the transmission of monetary policy to inflation.
A number of Central Banks, international organizations, and private sector financial organizations have adopted the MCI. MCIs may be rated superior to Central Bank setting the instrument alone. The two variables are chosen as they reflect the main channels of transmission of monetary policy to inflation. Used together in the MCI, they come with the advantage of simplicity but the setback of estimation difficulties and interpretation. Brand positioning

In their description of the monetary conditions index, Osborne-Kinch and Holton identify three ways of arriving at the weights of the MCI namely the single equation estimation, multiple equation based MCIs, and trade share based MCIs. They identify the single equation approach as the most common. The multiple equation based MCIs involve obtaining the weights from macro-econometric models with a number of equations or using vector autoregressions (VARS) relationships of GDP, exchange rates and interest rates. Trade share based MCIs are simpler to obtain. The exchange rate weight is based on the long run exports-to-GDP ratio and the interest rate weight obtained by one minus this ratio. Trade share based MCIs are criticized for their lack of detail about the effects of the relevant variables on the economy.
Okello and Opolot estimated the MCI using a reduced form of multiple equations. They argued that the multiple equations method was preferred as it captured the effects of foreign prices and interest rates on the domestic price level given that Uganda is a small open economy. Their finding was that the MCI ably captured the changes in domestic and external conditions and preferred it to the monetary aggregates M2 and M3 as an indicator of the monetary conditions given its frequent calculation. However, the monetary conditions index may not be used in isolation as an indicator or as an operating target in influencing inflation.
Kannan et al estimated a broad MCI incorporating credit growth as an additional indicator of monetary conditions for India. Their results revealed that the interest rate was more important than exchange rate in influencing monetary conditions in India. They found the MCI more effective to put together than any single indicator in order to provide a better assessment of the stance of monetary policy and demonstrated its role as a leading indicator of economic activity and inflation. While conceding that the MCI may not be the single solution to monetary policy conflicts, it systematically takes into account both easing and tightening of monetary conditions (and even credit, in case of broad MCI) so that there is no room for missing such counter-movements.

This post was written by , posted on January 27, 2014 Monday at 4:50 pm