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.

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''' 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 output and thus increase 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:

Where Φ is a parameter that tlls us how much unemployment rises when the [[central bank]] raises the [[real interst rate]] ''r'' because it thinks the [[inflation]] is too high and needs to be deduced.

'''u:r = u0r* + Φg(π -– πtπ*)

where

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

'''

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

The Slope''' of the MPRF is:

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

'''1/Φ'''

: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 ==

The MPRF is used hand in hand with the [[Phillips Curve]] to determine the effects of [[economic policy]]. This framework illustrates [[equilibrium]] levels of the [[unemployment rate]] and the [[inflation rate]] in a [[sticky-price model]].

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{{economics-stubCentral banks}}

[[Category:Monetary policy]]