MSc. Student: RAMONA STAN

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ACADEMY OF ECONOMIC STUDIES BUCHARESTDOCTORAL
SCHOOL OF FINANCE AND BANKING (DOFIN)
Dissertation paper

• MONETARY CONDITIONS INDEX (MCI)
• AS A SUMMATIVE INFORMATION TOOL FOR
  CHARACTERIZING
• THE MONETARY POLICY STANCE IN ROMANIA (1997
  2005)

BUCHAREST, JULY 2006
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CONTENTS

• Objectives
• What is the Monetary Conditions Index?
• Theoretic approach
• Econometric estimation
• Results
• Conclusions
• Bibliography

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1. OBJECTIVES

• MCI relevant information tool for
  characterizing the monetary policy stance in
  Romania between 1997-2005
• Would be worthwhile use a MCI for a better
  representation of monetary policy stance?
• Do indeed short-term interest rate and exchange
  rate directly influence both stability of the
  prices and aggregate demand?
• Controlled floating of the exchange rate
• To which extent tight control exercised by the
  National Bank of Romania (NBR) over the national
  currency depreciation rate influenced stability
  of the prices and real economic growth?
• Assessment of credibility and increased
  independency of NBR
• Is inflation rates slow yet continuous decrease
  to be credited only to NBRs quantitative
  approach with exchange rate constraints?
• What is the real place of the short-term
  interest rate within the monetary policy choices,
  considering it has been used only on short
  periods as operational target?

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1. OBJECTIVES
Why this historical recourse on monetary policy
choices?

• 1997
  2005
• If MCI relevant indicator ? significant
  indication on the success of the monetary policy
  ? better measurement of credibility and
  independency of the National Bank essential
  presumptions on which direct inflation targeting
  is based upon
• Intuitively higher relative influence of the
  exchange rate both over the prices and aggregate
  demand ? if proved ? clearly better
  representation in the future of the monetary
  policy stance by means of MCI
• Short-term interest rate inflation rate
  paradox
• Monetary policy choices throughout the analysis
  period
• Maastricht convergence criterion to be achieved
• Less powerful instrument? ? to be accounted for
  in the future

monetary base targeting
direct inflation targeting
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2. WHAT IS THE MONETARY CONDITIONS INDEX (MCI)?
MCI weighted sum of modifications in the
short-term interest rate and exchange
rate relative to some arbitrary date.
Basic assumption Monetary policy directly
influences inflation through short-term interest
rate and exchange rate.
Appealing operational target for monetary
policy (Ericsson et al., 1997)
Influence over aggregate demand
Controlling for exogenous shocks

Bank of Canada the pioneer in constructing
and using MCI as operational target. MCI used
either as operational target (New Zeeland) or
summative information tool (Norway, Sweden) by
Central Banks. MCI constructed for
international comparisons (IMF, Goldman Sachs, JP
Morgan).
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2. WHAT IS THE MONETARY CONDITIONS INDEX (MCI)?

• MCI can be used as
• Summative information tool
• Operational target
• Monetary policy rule
• Relevance directly depending on the choose of
  underlying model from
• which the weights are estimated
• Nominal versus Real MCI
• Secondary objective
• Base period closely to the long-run equilibrium
  relationship
• Econometric estimation
• Underlying model
• Choice of the variables
• Cointegration
• Stability of the coefficients
• Weak exogeneity
• White noise residuals

.
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2. WHAT IS THE MONETARY CONDITIONS INDEX (MCI)?

• MCI as a summative information tool
• Disadvantages/Limitations
• Relative stance of the monetary policy as
  compared to an arbitrarily chosen base period
• Voluntarily generalizing approach regarding
  transmission mechanism into the real economy
• Not a fundamental measure of monetary conditions,
  if nothing else, because neither MCI nor
  short-term interest are nominal anchors of the
  system
• Controlling for validity of hypothesis in
  econometric estimations ?
• Aggregation problem

other variables insignificant in characterizing
monetary policy stance particular exchange rate
out of many others foreign currencies basket ?
weights estimated from bilateral trade
statistics particular short-term interest rate ?
not accounting for the long-term interest rate
contribution to monetary policy choices
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3. THEORETIC APPROACH
UNDERLYING MODEL Aggregate demand equation
?y F(?R, ?e, ) Aggregate Phillips equation ?p
F(y-y, ?e, ) where ?y real growth rate
of GDP y-y output gap ?p inflation
rate ?R change in real interest rate ?e
change real exchange rate   and lower cases
express logarithm. The suspension points
replace the variables that are not representative
for monetary policy, thus through which the
influence of taxation and fiscal policy is
transmitted. The interest rate influences
inflation via the real GDP and thus linking the
two equations determines an extremely simplified
model, the so-called reduced-form model ? Bank
of Canadas inspiration for the construction of
MCI
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3. THEORETIC APPROACH
(0)
Let
Where is the real output
gap y and e logarithm rtf - external interest
rate (exogenous)
(1) (2) (3)
Conditional expectations at t1
(7)
(8)
Substituting in (6) and identifying coefficients
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4. ECONOMETRIC ESTIMATION

• Underlying model
• In practice, most Central Banks which constructed
  and used MCI have estimated the coefficients only
  from the aggregate demand equation and only in a
  less formal approach, mostly for benchmarking
  purposes, from the prices equation.
• aggregate demand equation
• ! prices equation ? first paradox short-term
  interest rate actual place in
• the monetary policy choices
• MCI relevant ?
• Estimation period 1997-2005
• Base period 2002 (neutral level)

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4. ECONOMETRIC ESTIMATION

• Choice of variables
• short-term interest rate BUBOR3M (3
  months-active interest rate)
• high volatility of the overnight market
• non-governmental credit high increase (owed also
  to facilities)
• similar trend of deposit-taking and
  deposit-placing interest rates
• exchange rate composite index including Euro
  and US Dollar
• reference foreign currency ? USD (until 2001) ?
  EUR
• compromise determined by short data series
• following the footsteps of NBR and IMF ?
  bilateral trade data
• BASKET 60 EUR 40 USD (1997-2003)
• 75 EUR 25 USD (2004-2005)
• prices index Consumer Prices Index (CPI) vs.
  Producer Prices Index (PPI)
• intimate relationship between exchange rate and
  PPI ? inflation rate
• final consumption ? 63 of GDP

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4. ECONOMETRIC ESTIMATION
Notations bb3m_n annualized nominal interest
rate BUBOR 3M bb3m_r annualized real interest
rate BUBOR3M (Fisher formula) cpi consumer
prices index, fixed base (first quarter
1997) infl_rate inflation rate, fixed base
(first quarter 1997) infl_rate_an annualized
inflation rate, fixed base (first quarter
1997) basket_n/basket_r nominal/real exchange
rate RON/BASKET gdp_n_sa nominal GDP
(de-seasonalized series) gdp_r_sa real GDP
(de-seasonalized series) defl GDP deflator,
fixed base (first quarter 1997)  

All variables expressed in logarithm have been
denoted as l_variable name (with the first
difference d_l_variable name). Tools Excel
(basic calculations), Eviews 4.1.
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4. ECONOMETRIC ESTIMATION
TESTING FOR INTEGRATION ORDER

• all nominal variables integrated of I(1)
• real GDP ? I(1)
• real exchange rate ? I(1)
• real interest rate ? I(0)
• Nominal MCI ? VEC model
• Real MCI ? alternative VAR model

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4. ECONOMETRIC ESTIMATION

• Nominal MCI ? VEC model
• EC(E,1) 2 2 4 4 L_GDP_N_SA BB3M_N L_BASKET_N
• cointegration test ? (5) intercept and trend in
  CE deterministic trend in VAR
• adjustment speed ? -0.837
• stability of the coefficients ? roots of
  characteristic polynomial lt 0.8795
• weak exogeneity ? A(2,1)0, A(3,1)0,
  accumulated probability 0.1211
• residual tests
• no serial correlation (12 lags tested)
• normality (p-value 0.1093 to Jarque-Bera)
• homoschedasticity (0.2373 to Chi-sq)

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4. ECONOMETRIC ESTIMATION
Estimation of the weights

• Accumulated response over a year
• accounts for weak exogeneity
• NBRs projections do not go further that one
  year time horizon
• Period L_GDP_N_SA BB3M_N L_BASKET_N
• 1 0.015094 -0.006521 -0.003309
• 2 0.020505 -0.013666 0.001235
• 3 0.022820 -0.014561 0.012770
• 4 0.023901 -0.016247 0.025115
• Generalized Impulse

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4. ECONOMETRIC ESTIMATION

• Real MCI ? VAR model
• LS 1 2 D_L_GDP_R_SA BB3M_R D_L_BASKET_R
  _at_ C
• acceptable compromise, provided VAR is stable
  and the other hypothesis are tested.
• quasi-elasticity of GDP to the changes of the
  exchange rate
• how GDP changes if short-term interest rate
  changes by one percentage point?
• Controlling for relevancy of the model
• cointegration test (performed for the levels of
  the data) ? (1) / (5)
• stability of the coefficients ? roots of
  characteristic polynomial lt 0.8762
• weak exogeneity ? hypothesis rejected for the
  long-run equilibrium relationship
• residual tests
• no serial correlation (12 lags tested)
• normality (p-value 0.1983 to Jarque-Bera)
• homoschedasticity (p-value 0.0368 to Chi-sq)

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4. ECONOMETRIC ESTIMATION
Estimation of the weights
Period D_L_GDP_R_SA BB3M_R D_L_BASKET_R
1 0.021869 0.001525 0.002641
(0.00269) (0.00380) (0.00379) 2
0.014706 -0.001073 0.002787
(0.00435) (0.00458) (0.00466) 3
0.017028 -0.007088 0.009022
(0.00478) (0.00531) (0.00587) 4
0.017572 -0.006921 0.010883 (0.00529)
(0.00677) (0.00693) Generalized
Impulse Standard Errors Analytic
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4. ECONOMETRIC ESTIMATION
Controlled floating ? direct influence over the
aggregate demand?
LS 1 2 4 4 L_GDP_N_SA D_L_BASKET_N BB3M_N _at_ C

• Controlling for relevancy of the model
• cointegration test
• stability of the coefficients ? one root of
  characteristic polynomial gt 0.97 ?!
• weak exogeneity ? hypothesis rejected
• residual tests
• no serial correlation (12 lags tested) ? at lag
  4 (p-value 0.0597)
• normality (p-value 0.0781 to Jarque-Bera)
• homoschedasticity (p-value 0.5726 to Chi-sq)

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5. RESULTS
Notations MCI_2002_RFREE_BB3M ? Real
MCI MCI_2002_NFREE_BB3M ? Nominal
MCI MCI_2002_GDP2002_N_BB3M ? Nominal MCI
(controlled floating)
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5. RESULTS

• Nominal MCI ? ease of monetary conditions
• Real MCI ? tightening of monetary conditions

?

• high inflation rate throughout the period
• controlled floating ? appreciation in real terms
  of the
• national currency

2004-2005 preparation for direct inflation
targeting ease of control exercised over the
exchange rate appreciation both in real and
nominal terms Tighter than intended monetary
conditions !
1997-1999 difficult times for Romania three
years of real negative growth of GDP peaks of
foreign debt service almost financial crisis
in 1999
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5. RESULTS
Positive signal regarding NBR credibility and
independency

• fairly accurate representation of monetary
  policy success in controlling stability of the
  prices ? after 2002
• high minimum mandatory reserves ? allowed for
  decrease of the interest rate
• other external shocks to the inflation

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6. CONCLUSIONS

• the relative influence of the exchange rate and
  short-term interest rate
• 1.551 (1.571 in real terms)
• SUCCESS OF DIRECT INFLATION TARGETING ? MCIs
  LESSONS
• lower power of the short-term interest rate to
  induce changes of aggregate demand
• matter of concern for future monetary policy
  choices
• proven importance of the exchange rate
  (stability of the prices, economic growth)
• better measurement of monetary conditions with
  MCI
• need to pay attention still for the monetary
  base growth rate
• motivation of quantitative approach (taking also
  into account real facts)

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6. CONCLUSIONS

• LIMITATIONS OF MCI
• interest rate inflation paradox ? MCI might
  not be a relevant indicator of the monetary
  policy stance
• need to construct an alternative MCI including
  all monetary variables of importance in achieving
  final inflation target
• relevancy of coefficients
• short time series (Bank of Canada calculations
  on MCI cover 1980-2006!!)
• relative importance of the shocks induced to
  aggregate demand (based on the impulse-response
  functions) are acceptable to the limit
• aggregation problem ? the way the basket was
  constructed

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BIBLIOGRAPHY
Balázs Égert, László Halpern (2005), Equilibrium
Exchange Rates in Central and Eastern Europe A
Meta-Regression Analysis, William Davidson
Institute Working Paper no. 769 Batini,
Nicoletta. Turnbull, Kenny (2000) Monetary
Conditions Indices for the UK A Survey.,
External MPC Unit Discussion Paper No. 1 Bank
of England Benoit, Anne (2000), Indicators of
Monetary policy orientation Monetary conditions
(MCI) and the Taylor rule, Erste Bank. Botel,
Cezar (2002), Determinants of inflation in
Romania. June 1997 August 2001. Analysis based
on Structural VAR, National Bank of Romania
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(2001), Monetary Conditions and stock returns a
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Coping with the Inflation and Exchange Rate
Shocks in the South African Economy, The South
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Hazards in Implementing a Monetary Conditions
Index, Federal Reserve System IFD Paper No.
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Kerbeshian, Neva A., Nymoen, Ragnar. (1997),
Understanding a Monetary Conditions Index,
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Design Flaws in the Construction of Monetary
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Department of Economics University of Canterbury
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The Central Bank Of The Republic of Turkey.
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