This
paper employs the bounds testing approach for cointegration
analysis (Pesaran et al., 2001) to examine the impact of
interest rate and exchange rate on output, and then uses
the estimated weights to construct Monetary Conditions Index
(MCI) for Singapore over the quarterly period 1981-2004.
Designed to measure the stance of monetary condition, MCI
plays an important role for the conduct of monetary policy.
Results reveal evidence of a long-run cointegration between
the output and its determinants, namely short and long-term
interest rate, exchange rate, and claims on the private
sector. This has further verified the stability of the Singaporean
output demand function. The study has evidently showed that
the Monetary Authority of Singapore has responded positively
to the MCIs in terms of the monetary policies stance.
Gerlach and Smets (2000) demonstrate that it is optimal for the central bank to conduct policy using an MCI, consisting of a weighted average of the short-term interest rate and exchange rate. The weights are given by the interest and exchange rate elasticities of Aggregate Demand (AD). Several central banks have attempted to estimate these elasticities in order to construct empirical MCIs. In practice, the relative short-term interest rate and exchange rate elasticities of demands have been used to guide as to how much the policy instrument has been adjusted, given the unexpected changes in the exchange rate. Both the interest rate and the exchange rate are important observable and continuously financial prices, particularly for open economies. Interest rate affects AD households as well as the intertemporal investment decisions of firms. Meanwhile, the exchange rate influences AD through its impact on the relative price of domestically versus foreign-produced goods. |
