Measuring monetary conditions in a small open economy: the case of Malaysia

Abstract

Purpose

The purpose of the paper is to gauge the usefulness of the Monetary Condition Index (MCI) and Financial Condition Index (FCI) for the conduct of monetary policy in Malaysia.

Design/methodology/approach

The MCI is constructed as the weighted sum of changes in the exchange rate and interest rate from their levels in a chosen base year. The weights are obtained by summing up the coefficients on the lags variables from estimating the determinants of backward‐looking aggregate demand.

Findings

The paper finds that the movement inflation induces the movement in either interest rate or exchange rate. The result also indicates that the interest rate channel is found to be more powerful than the exchange rate channel. The method in determining the weights for each policy component of the index however indicates some degree of instability due to some external shock affected the exchange rate or the domestic short‐term interest rate.

Originality/value

In a small open economy with deregulated markets, it is crucial to assess the combined effect of interest rate and exchange rate on monetary conditions and the conduct of monetary policy. Despite the index ability to explain monetary conditions in Malaysia, the estimate of MCI and FCI should be used cautiously. The index does not offer a precise signal on the state of monetary condition in Malaysia.

Citation

Zulkhibri Abdul Majid, M. (2012), "Measuring monetary conditions in a small open economy: the case of Malaysia", Journal of Financial Economic Policy, Vol. 4 No. 3, pp. 218-231. https://doi.org/10.1108/17576381211245953