Monetary Conditions Indices and the Term Structure of Interest Rates

Abstract

A monetary conditions index is a weighted average of an interest rate and an exchange rate. This paper introduces a model for pricing interest rate and exchange rate contingent claims when a central bank uses open market operations to keep a monetary conditions index inside a band. The model is applicable to Canada and New Zealand, where the central banks conduct monetary policy with the (intermediate) objective of achieving a desired level of a monetary conditions index. The model is calibrated to New Zealand data and the consequences for the behaviour of the domestic yield curve are investigated. Possibilities for improved management of interest rate and exchange rate risk are demonstrated.