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.

    Key Takeaways

    • The monetary conditions index (MCI) is a way to use short-term interest rates and the exchange rate of a nation to assess the relative ease or tightness of its monetary conditions.
    • Central banks use the MCI as a tool in helping shape monetary policy.
    • The first MCI was developed by the Bank of Canada in the 1990s to assess the relationship between Canada's exchange rate and its economy.
    • Each nation will calculate its MCI in a different way but the goal is to assess the relationship between the changes in a country's interest rates and exchange rates from a base period.

    Understanding the 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 a 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.

    Calculating the Monetary Conditions Index (MCI)

    Though each nation will calculate its MCI slightly differently, the goal is to assess the relationship between the changes in the interest rate and the exchange rate from a base period. Canada, for example, has changed how it calculates its MCI a few times.

    From 1987 to 1999, the MCI calculation used the change in the 90-day  commercial paper  rate, then added 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 averaged the currencies of six of Canada's major 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 a new method.   In 2018, the MCI calculation moved to the nominal Canadian effective exchange rate (CEER). This is a weighted average of bilateral exchange rates for the CAD against the currencies of Canada's most prominent trading partners.  

    Currently, CEER includes 17 currencies.   The countries include those that account for at least 0.5% of

    • Canadian non-oil exports (for a total of more than 93% of those exports)
    • Canadian non-oil imports (for a total of more than 91% of those imports)  

    The major currencies of the 17 currencies include the U.S., Japan, U.K., Switzerland, Australia, and Sweden.  

    Growing Use of the Monetary Conditions Index (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 the Organisation for Economic Co-operation 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 weights 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 the monetary policy.

    What is MCI economics?
    A Monetary Conditions Index (MCI) is an index number calculated from a linear combination of the short-run interest rate and the exchange rate. more
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    Source: www.investopedia.com

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