ABSTRACT
In a regime of floating exchange rates and mobile capital, both the interest rate and the exchange rate are important components in the transmission of monetary policy to inflation. Central banks in small open economies have little choice over the specific combination of the two components, but larger economies such as the United States and the euro area can make a choice, especially if they co-ordinate their actions. 2 The more ‘open’ the economy, the greater the importance of the exchange rate tends to be_ Central banks have undertaken to estimate the effect of exchange rates and communicate it to financial markets. A common communication device employed by central banks, international organisations, and private-sector financial institutions has been to combine interest rates and the exchange rate into a single indicator of monetary conditions, an MCI (monetary conditions index). MCIs are weighted sums of the variables that the central bank influences directly by monetary policy. As a means of summarising the setting of monetary pressures on the economy, they may be superior to referring to central bank instruments alone. The variables chosen reflect the main channels of transmission of monetary policy through to inflation. The weights reflect their relative importance. In practice most MCIs include just a short interest rate and a measure of the exchange rate, 3 both usually in real terms, although some private-sector organisations have begun to add other asset prices. 4
