Monetary policy implementation frameworks are based on monetary policy transmission mechanism. In small open economies, the monetary policy transmission mechanism depends on the depth of the financial market, the degree of financial innovation, the intensity of international capital flows and the extent of trade openness. Financial deepening links the financial and the real sectors closely and where the domestic financial market of a country is well linked to the global financial market, exchange rate will be an important channel of monetary policy transmission to the real economy.
Conceptually, a change in Monetary Conditions Index is taken to mean the extent of tightening or easing of the monetary conditions; in which a number is used to summarise the degree of pressure that monetary policy exerts on the economy. The use of MCI is premised on the assumption that monetary policy impacts general price level principally through two channels, namely: interest rates and exchange rates. When monetary policy stimulates interest and exchange rates in the upward direction, inflation rises and generates economic slowdown through fall in aggregate demand and vice versa (Kesriyeli and Kocaker, 1999).
The level of investment and domestic demand are usually influenced by interest rates. Adjustments to the interest rate elicit reaction in market interest rates, both short- and long-term. The effects of adjustments in market interest rates usually influence savings and lending rates. Changes in the saving rate tend to impinge on the spending pattern of individuals while changes in the lending rate have effects on firms’ investment decisions. Also, variations in aggregate consumption and investment are directly linked to changes in the gross domestic product (GDP).
In the second channel, exchange rate plays a dominant role. The exchange rate is the relative price of foreign currencies vis-à-vis domestic currency. Ideally, both foreign and domestic monetary conditions should have influence on the exchange rate. Adjustment in the exchange rate alters the relative prices of domestic and foreign goods and services. Price movement affects economic agents’ spending patterns. Exchange rate changes can also affect inflation rate directly, with the transmission coming through the prices of imported goods. In today’s global economy, imported goods constitute important determinants of firm’s costs and individuals’ consumption expenditures. Domestic currency appreciation tends to lower the domestic price of imports, while depreciation of the domestic currency increases the price of imported goods. Hence, another key channel through which monetary policy actions are transmitted to the ultimate objectives of policy, which include inflation and output in a small open economy, is the exchange rate.