TheA '''monetary policy reaction function''' isdescribes how a function[[central thatbank]] givessystematically theadjusts value of aits [[Central bank#Policy instruments|monetary policy toolinstruments]] thatin aresponse [[centralto bank]]changes chooses,in oreconomic isconditions. recommendedThis tofunction choose,provides ina responseframework tofor someunderstanding indicatorhow ofcentral banks make policy decisions based on observable [[economy|economic conditions]]indicators.
==Examples==
OneThe suchmost influential reaction function is the [[Taylor rule]], developed by economist John Taylor in 1993. ItThe rule provides a systematic formula for specifiessetting the [[nominal interest rate]] setbased byon thefour centralkey bankvariables: inThe reactiondeviation toof thecurrent [[inflation rate]], from the assumedcentral long-termbank's target; The current [[real interestinflation rate]],theitself; deviationThe ofequilibrium the[[real inflationinterest rate]]; fromand itsthe desired[[output valuegap]], andmeasured the log ofas the ratiopercentage ofdifference realbetween actual [[GDP]] (output) toand [[potential output]].
Alternatively,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>{{full|date=August2013}}Their presentsimplified theversion function,describes ina its simplest form, as an upward-slopingpositive relationship between the [[real interest rate]] and the [[inflation rate]], where central banks respond to rising inflation by increasing real interest rates:
:r = r* + g(π – π*)
Line 16:
: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.
