The monetary policy reaction function is a function that gives the value of a
monetary policy tool that a
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central b ...
chooses, or is recommended to choose, in response to some indicator of
economic conditions.
Examples
One such reaction function is the
Taylor rule
The Taylor rule is a monetary policy targeting rule. The rule was proposed in 1992 by American economist John B. Taylor for central banks to use to stabilize economic activity by appropriately setting short-term interest rates.
The rule consider ...
. It specifies the
nominal interest rate In finance and economics, the nominal interest rate or nominal rate of interest is the rate of interest stated on a loan or investment, without any adjustments or fees. Examples of adjustments or fees
# An adjustment for inflation(in contrast with ...
set by the central bank in reaction to the
inflation rate
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
, the assumed long-term
real interest rate
The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approxi ...
, the deviation of the inflation rate from its desired value, and the log of the ratio of real
GDP
Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjective nature this measure is ofte ...
(output) to
potential output
In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (potential output) that can be sustained over the long term. Actual output happens in real life while ...
.
Alternatively,
Ben Bernanke and
Robert H. Frank
Robert Harris Frank (born January 2, 1945) is the Henrietta Johnson Louis Professor of Management and a professor of economics at the Samuel Curtis Johnson Graduate School of Management at Cornell University. He contributes to the "Economic View" ...
[Bernanke, Ben, and Frank, Robert. ''Principles of Economics'', 3rd edition.] present the function, in its simplest form, as an upward-sloping relationship between the real interest rate and the inflation rate:
:r = r* + g(π – π*)
where
:r = current target real interest rate
:r* = long-run target for the real interest rate
:g = constant term (or the slope of the MPRF)
:π = actual inflation rate
:π* = long-run target for the inflation rate
References
{{Reflist
Monetary policy