Design Flaws in the Construction of Monetary Conditions Indices? A Cautionary Note
Abstract: Monetary conditions indices featured prominently as instrument variables or operating targets, particularly in the inflation-targeting countries during the1990s. In this paper, we show that conventional monetary conditions indices are potentially mis-specified. Under a regime of strict inflation targeting, conventional MCIs are unreliable indicator variables or operating targets if there is a direct exchange rate effect on the rate of inflation in the Phillips Curve. We also point to the limitations of a standard MCI under strict inflation targeting. The policymaker can circumvent these limitations by redefining the inflation target. Nevertheless, from a general perspective the usefulness of MCIs in the conduct of monetary policy is doubtful in view of their model-specific nature.
JEL classification: E52, F41