Accurate measures of the size and direction of changes in
monetary policy are very important. A number of variables/indicators
have been used as a measure of the stance of monetary policy the world
over. These include growth rates of monetary aggregates and credit
aggregates, short-term interest rate as used by Sims (1992), index of
minutes of Federal Open Market Committee (FOMC), as suggested by
Friedman and Schwartz (1963) and reintroduced by Romer and Romer (1989),
monetary policy index constructed by employing Vector Autoregression
(VAR) estimation technique with prior information from Central Bank such
as Bernanke and Blinder (1992) and Bernanke and Mihov (1998), and
Monetary Conditions Index (MCI)—which is the focus of this
paper—constructed by and used by Bank of Canada [Freedman (1995)],
taking into consideration the interest rate and exchange rate channel of
monetary policy transmission mechanism in a small open economy. In case
of open economy it is assumed that the monetary policy affects the
economy and the prime objective of monetary policy, rate of inflation,
through two important transmission mechanisms. These transmission
channels are; interest rate channel and exchange rate channel. The
working of the first channel is that the interest rate influences the
level of expenditures, investment and subsequently domestic demand. The
change in official interest rate effects the market rates of interest
both short term as well as long term interest rates. This change in
market rates of interest is transmitted to the bank lending rates and
saving rates. The change in saving rate effects the spending behaviour
of individuals (consumption) whereas the change in bank lending rate
effects the investment behaviour of firms (investment). The change in
aggregate consumption and investment has direct link to the gross
domestic product (GDP).