Constructing a New Monetary Condition Index for Iran

Reliable measures of the size and direction of changes in monetary policy are very crucial for examining the effects of monetary policy on the economy. Monetary Condition Index (MCI) can be used as a tool to assess the stance of monetary policy. This index is defined as the weighted average of different monetary transmission mechanism relative to their valuesin a base period. The weights in MCI are the relative importance of each channel in transmitting monetary shocks in the economy. In this paper we construct a new MCI for Iran that characterizes three key innovations. First, for estimation of MCI’s weights, we employ system of equations (VARX) in order to solve the problem of exogeneity arising from single equation method. Second, beside exchange rate and credit channel, it includes asset price channel. Third, we utilize a quarterly data set which seems more plausible for studying short-run dynamics regarding the monetary policy. Our estimated index over the 1991Q2-2014Q1indicates that in more than 74% of quarters under consideration, monetary condition in Iran is easing relative to the base period (2004:2). The empirical results show MCI leads roughly 1 quarter ahead of inflation. Therefore, this index can be used as the leading indicator of the inflation rate.