Monetary policy reaction function: Difference between revisions

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A '''monetary policy reaction function''' describes how a [[central bank]] systematically adjusts its [[Central bank#Policy instruments|policy instruments]] in response to changes in economic conditions. This function provides a framework for understanding how central banks make policy decisions based on observable economic indicators.

''' The Monetary Policy Reaction Function (MPRF)''' is the upward-sloping relationship between the inflation rate and the unemployment rate. When the inflation rate rises, a central bank wishing to fight inflation will rise interst rates to reduce ioutput and thus inrease the unemployment rate.

The MPRF is a function of ''[[the Taylor Rule]]'', the ''[[Investment-Spending Curve (IS Curve)]]'' and ''[[Okun's Law]]''

==Examples==

The MPRF has the equation:

The most influential reaction function is the [[Taylor rule]], developed by economist John Taylor in 1993. The rule provides a systematic formula for setting the [[nominal interest rate]] based on four key variables: The deviation of current [[inflation rate]] from the central bank's target; The current [[inflation rate]] itself; The equilibrium [[real interest rate]]; and the [[output gap]], measured as the percentage difference between actual [[GDP]] and [[potential output]].

'''u = u0 + Φ(π - πt)

'''

An alternative formulation of the monetary policy reaction function was proposed by [[Ben Bernanke]] and [[Robert H. Frank]].<ref>Bernanke, Ben, and Frank, Robert. ''Principles of Economics'', 3rd edition.</ref> Their simplified version describes a positive relationship between the [[real interest rate]] and the [[inflation rate]], where central banks respond to rising inflation by increasing real interest rates:

'''u:r = u0r* + Φg(π -– πtπ*)

where

:r = current target real interest rate<br />

:r* = long-run target for the real interest rate<br />

:g = constant term (or the slope of the MPRF)<br />

:π = actual inflation rate<br />

:π* = long-run target for the inflation rate

This linear relationship provides a more straightforward framework compared to the multi-variable Taylor rule, though it captures fewer economic factors.

== References ==

{{Reflist}}

{{Central banks}}

[[Category:Monetary policy]]