The specification of the monetary policy reaction function ensures that the policy rate (𝒊_𝒕) changes to a greater extent in response to a deviation of expected inflation from the target (𝝅^𝟒_𝒕+𝟒 − 𝝅^𝒕𝒂𝒓_t+4)  and  a lesser extent in response to the output gap (𝒚̂_𝒕). 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:

 

                    𝒊_𝒕 = 𝛾₁𝒊_𝒕−𝟏 + (1 − 𝛾₁)[𝒊^𝑵_t + 𝛾₂𝐸_𝑡(𝝅^𝟒_𝒕+4 − 𝝅^𝒕𝒂𝒓_t+4) + 𝛾₃𝒚̂_𝒕] + 𝜺^𝒊_t − 𝛾₄𝜺^𝒕𝒂𝒓_t

 

where,

𝒊_𝒕 - monetary policy rate
𝒊_𝒕−𝟏 - lag of monetary policy rate 
𝒊_𝒕^𝑵 - neutral monetary policy rate
𝝅^𝟒_𝒕+4 - inflation expectation
𝝅^𝒕𝒂𝒓_t+4 - inflation target
𝒚̂_𝒕- output gap
𝜺^𝒊_t - monetary policy rate shock
𝜺^𝒕𝒂𝒓_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.