Broad Money Supply and Financial Condition Index for Indian Economy

Abstract

In the context of recent global financial crisis, the impact of exogenous shock to the financial sector on the real sector of the economy has come to the notice of the economists all over the world. The traditional dichotomy between financial and real sector is found to be inadequate for either managing or predicting the economy's overall behavior. In view of this recent development, this paper makes an attempt to construct a Financial Condition Index (FCI) in the context of Indian economy, to explore the possibility of how such an index would be an improvement over the traditional Monetary Condition Index (MCI), which has been the central bank's main instrument. The FCI is constructed by incorporating broad money supply along with real interest rate and official exchange rate. Following a weighted sum approach, the index is constructed by taking into consideration macroeconomic data over two decades of time period. The FCI, thus constructed, shows a significant co-relationship with the variability economy's inflation rate, revealing its usefulness as an indicator for early warning system for Indian economy.