Academic journal article IUP Journal of Applied Economics

Different Interest Rates - Is It a Concern in Constructing Augmented Monetary Conditions Index?

Academic journal article IUP Journal of Applied Economics

Different Interest Rates - Is It a Concern in Constructing Augmented Monetary Conditions Index?

Article excerpt

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Monetary Condition Index (hereafter MCI) is defined as the weighted sum of the percentage change in the real interest rate and the percent change in the real exchange rate, relative to the base period (Freedman, 1995, p. 75; and Batini and Turnbull, 2002, p. 259). It is constructed by combining both the interest rate and exchange rate in a single policy indicator, while keeping the central bank's and the financial market's focus on the economic conditions relevant to the medium-term inflation outlook. Despite the fact that it is not easy to understand how policy makers assess the degree of tightening or easing of the monetary policy in the dynamic environment, Freedman (1994 and 1995), Nadal-De Simone et al. (1996) and Hataiseree (1998, p. 1) claim that MCI serves as a base indicator in determining the overall monetary policy stance. More than a decade ago, Freedman (1994) and Eika et al. (1996) had recognized the limitations of using MCI as an operational target for monetary policies, because MCIs constructed based on historical relationships could become unreliable over time due to structural changes in the economy.

The index is influenced by other variables apart from the two transmission mechanism channels, i.e., the interest rate and exchange rate, which have been addressed in constructing the conventional MCIs (Peng, 2000; Siklos, 2000; and Peng and Leung, 2005). Using different proxies of interest rate and exchange rate will cause the weights of MCIs to differ among countries. Even for the same country, it might have more than one index (Ericsson et al., 1998). Obviously, the selection of variables is an important issue in determining the weights of the MCI. From this perspective, the choice of short-term interest rate in constructing MCIs may be of grave concern for central bankers and market participants. The short-term interest rate should ideally be under the influence of the central bank and responsive to changes in money market conditions. In Canada, for example, the 90-day commercial paper rate as a proxy for the short-term market interest rate was used in calculating MCIs, while bank deposits are not suitable to be used because they are 'administered' rates reflecting chartered banks' market power (Shearer et al., 1995, pp. 293-341). They would change more or less in the same direction of the market interest rates in the long run; they are not, at least in the short run, in response to changes in monetary conditions. Similar reason is applied for both lending rate and Treasury bill rate.

The small and open Singapore economy, famous for its entrepot and dynamic international trade, is the third largest and active financial center in the Asia region after Japan and Hong Kong. Singapore economy is much more open to international trade than many countries. For instance, observing 2007 current price national accounts at PPPs, the openness of 426.68% for Singapore was much higher as compared to: (1) OECD countries (such as 55.23% for UK, 29.07% for US, 41.26% for Australia, and 56.20% for New Zealand); (2) East Asian countries (such as 139.46% for Taiwan, 91.73% for Korea, 404.11% for Hong Kong, 70.98% for China, and 33.5% for Japan); and (3) South-East Asian countries (such as 200.08% for Malaysia, 54.32% for Indonesia, and 88.83% for the Philippines) (Penn World Table). Hence, Singapore credit channel of the monetary transmission mechanism is particularly important in financial intermediation, and banks' credit availability has important supplementary effects on the monetary policy transmission (Bernanke and Gertler, 1995).

The Monetary Authority of Singapore (MAS) has adopted a unique framework that centers on managing the effective exchange rate since 1981, instead of money supply and interest rate, for some form of price stabilization objective, to keep inflation low, where Singapore dollar is discretely adjusted against an undisclosed currency basket that is allowed to fluctuate within a policy band (which is commonly referred to by MAS as Band, Basket and Crawl, BBC1). …

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