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Monetary conditions index (MCI) is used as an intermediate target of monetary policy in many developed countries. More recently, monetary authorities in some developing countries have also attempted to use this operational target to determine the stance of monetary policy in their countries. The MCI is usually computed as a weighted sum of changes in interest rate and exchange rate. The use of interest rate in constructing MCI might not be appropriate in developing countries due to the lack of efficient financial markets in these countries. Some authors have emphasized on the role of credit channel in monetary transmission mechanism for developing countries. Using weighted sum of profit rate, exchange rate and banks credit, this paper constructs proper MCI for the Iranian economy. Aggregate demand and price equations are used to estimate the weights. Finally, the forecasting power of these indices using non-nested tests and root mean square errors is compared. The results show that the MCI augmented with banks credit has better predicting power than those without credit channel. Moreover, it is also revealed that real MCI, as an intermediate target, is preferred to nominal ones.

Keywords: Monetary policy, E58, Monetary Conditions Index (MCI), Credit channel, Non-nested tests, Iran. JEL Classification: E52, E58

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