Monetary policy reaction function

    The specification of the monetary policy reaction function ensures that the policy rate (๐’Š๐’•) changes to a greater extent in response to a deviation of expected inflation from the target (๐…๐Ÿ’๐’•+๐Ÿ’ − ๐…๐’•๐’‚๐’“t+4)  and  a lesser extent in response to the output gap (๐’šฬ‚๐’•). However, interest rates do not change instantaneously, rather they are characterized by certain inertia, since the monetary policy should be consistent and the risks to macroeconomic forecasts are high. All of the above-mentioned are expressed in the following specific function:

     

                        ๐’Š๐’• = ๐›พ1๐’Š๐’•−๐Ÿ + (1 − ๐›พ1)[๐’Š๐‘ตt + ๐›พ2๐ธ๐‘ก(๐…๐Ÿ’๐’•+4 − ๐…๐’•๐’‚๐’“t+4) + ๐›พ3๐’šฬ‚๐’•] + ๐œบ๐’Št − ๐›พ4๐œบ๐’•๐’‚๐’“t

     

    where,

    ๐’Š๐’• - monetary policy rate
    ๐’Š๐’•−๐Ÿ - lag of monetary policy rate 
    ๐’Š๐’•๐‘ต - neutral monetary policy rate
    ๐…๐Ÿ’๐’•+4 - inflation expectation
    ๐…๐’•๐’‚๐’“t+4 - inflation target
    ๐’šฬ‚๐’•- output gap
    ๐œบ๐’Št - monetary policy rate shock
    ๐œบ๐’•๐’‚๐’“t - shock stemming from the change in inflation target 


    Alongside the monetary policy reaction function, the basic macroeconomic model mainly consists of the aggregate demand, aggregate supply and uncovered interest rate parity equations.