Once upon a time, running the monetary policy was a simple affair. Central banks simply totted up how much currency there was in the economy and either reduced it if they wanted to raise interest rates, or increased it if they wanted to lower them. It was easy as falling off a log, and only the timing of the intervention mattered.

Alas, no longer. Money has become cash, plus lots and lots and lots of credit, plus all kinds of dodgy instruments such as collateralised debt obligations (CDOs), to name just one, that traders have dreamt up over the last 20 years.

The result is that central banks have become like the little Dutch boy who so heroically stuck his finger in the dyke. To make matters worse, their troubles have been compounded by the more open capital regimes.

Money in all its glory and forms, divyarupam as the Bhagwad Gita would say, flows in and out of open economies at will. This thrills traders who thrive on commissions but central banks get nightmares. They can only keep their fingers crossed that the boat won't capsize.

But that doesn't prevent violent rocking, of the sort we are seeing now. Economists, because they love to make simple things hard, call it volatility. The traders love it. They make money whatever happens to the market.

R Kannan, Siddhartha Sanyal and Binod Bihari Bhoi, in a recent paper, have tried to figure out how best to solve the problem that central bankers are facing. Following a practice that was started by the Bank of Canada and emulated by several other countries, they have constructed "a monetary conditions index (MCI) for India in order to take both interest rate and exchange rate channels simultaneously into consideration while evaluating the stance of monetary policy and evolving monetary conditions." A 'broad' MCI has also been constructed which incorporates credit growth as an additional indicator of monetary conditions... The index is the "weighted sum of the change in the short-term interest rate and exchange rate relative to a base period, with the weights being generally derived from empirical econometric models reflecting estimated impact of these variables on output or inflation."

They say that an index of this type is useful because it can be used either as an operational target or as a monetary policy rule or, when the need arises, "as an indicator of policy stance". The point is simply that an index is a single number, like the Sensex, that helps in finding out what is going on in the shady world of money. The MCI would tell us if there is tightening or easing of the monetary conditions.

They find that for India it is the interest rate and the not the exchange rate that matters more for monetary determining conditions. Their index "provides a better assessment of the stance of monetary policy and reveals its role as a leading indicator of economic activity and inflation."

Since an index must have separate weights for the variables that go into it, the authors have calculated such weights for interest rates and exchange rates. Their calculations lead up to a weight of 0.58 for the interest rate and 0.42 for the exchange rate. Clearly, if it is overall demand in the economy that monetary policy is trying to influence, it will have to fiddle the interest rates more than the exchange rates.

It is difficult to decide just how the index will work in practice. But in the absence of anything else, and because others have tried it without too many problems, it might be useful to give it a shot.

*Monetary Conditions Index for India, Reserve Bank of India [Get Quote] Occasional Papers, Vol. 27, No. 3, Winter 2006