This paper constructs the Monetary Conditions Index (MCI) over the quarterly period 1983:2-2004:4, using the bounds test approach proposed by Pesaranet al. (2001). The bounds test evidently reveals long-run relationship between the real GDP and its determinants, i.e., long-term interest rate, real exchange rate and share prices, which take into account the interest rate, exchange rate and asset price channels through which the monetary policy is transmitted. The paper also verifies the stability of the Indonesian output demand function that is used to construct the augmented MCI. It is observed that the monetary policy stance taken by the Bank Indonesia corresponds well to the movement of the augmented MCI after the Asian Financial Crisis.

Monetary Conditions Index (MCI) is constructed by combining both interest rate and exchange rates in a single policy indicator, keeping the central bank and financial markets' focus on the economic conditions relevant to the medium-term inflation outlook, and it serves as a better indication of the policy stance (Freedman, 1995; and Nadal-De Simone et al., 1996). MCI concept was initially discussed by Crow (1992). It was then conferred by Freedman (1994) and further scrutinized by Eika et al. (1996). The purpose of constructing MCI is to assess how restrictive a country's monetary policy is, using a synthetic index that shows the joint effects of variations in the interest and exchange rates on inflation and economic activity (Frochen, 1996). The MCI ratio is particularly helpful in assessing, how the overall degree of monetary constraint evolves when interest rate and exchange rate are moving in opposite directions, as has often been the case in practice (Brash, 1997, p. 5).

MCI is featured eminently as an operational target, as an indicator of monetary policy stance, or as an instrument in monetary policy regime (Batini and Turnbull, 2002). According to Freedman (1995), when MCI is used as a policy indicator, it keeps track of both interest rate and exchange rate movements and their effects on Aggregate Demand (AD). When MCI acts as an operational target indicator within the administration of monetary policy, it acts as a means of signalling the view of central bank regarding the appropriate policy stance and represents the relative degree of severity whether a policy has become loose or tight relative to a benchmark period. However, the use of MCI as an operational target or as an indicator tool has been de-emphasized in New Zealand (RBNZ, 1998) and Canada (Freedman, 1996). Eika et al. (1996), King (1997), Svensson (1997), Ericsson et al. (1998), Stevens (1998), Siklos (2000) and Gauthier et al. (2004), have critically assessed the problems associated with MCI in the conduct of monetary policy. The purpose of this paper is to understand the historical formulation of policy and examine whether the augmented MCI can be used as a direct policy-communication instrument to track the performance of the Gross Domestic Product (GDP) in Indonesia.

Applied Economics Journal, Monetary Conditions Index, MCI, Gross Domestic Product, GDP, Asian Financial Crisis, Financial Markets, Monetary Policy Regime, Autoregressive Distributed Lag, ARDL, Empirical Model Framework, Jakarta Composite Index, JCI, Financial Statistics, Unrestricted Error Correction Model, UECM, Ordinary Least Square, OLS, Null Hypothesis.