Monetary policy reaction function

    The specification of the monetary policy reaction function ensures that the policy rate (𝒊𝒕) changes to a greater extent in response to a deviation of expected inflation from the target (𝝅𝟒𝒕+𝟒 − 𝝅𝒕𝒂𝒓t+4)  and  a lesser extent in response to the output gap (𝒚̂𝒕). 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:


                        𝒊𝒕 = 𝛾1𝒊𝒕−𝟏 + (1 − 𝛾1)[𝒊𝑵t + 𝛾2𝐸𝑡(𝝅𝟒𝒕+4 − 𝝅𝒕𝒂𝒓t+4) + 𝛾3𝒚̂𝒕] + 𝜺𝒊t − 𝛾4𝜺𝒕𝒂𝒓t



    𝒊𝒕 - monetary policy rate
    𝒊𝒕−𝟏 - lag of monetary policy rate 
    𝒊𝒕𝑵 - neutral monetary policy rate
    𝝅𝟒𝒕+4 - inflation expectation
    𝝅𝒕𝒂𝒓t+4 - inflation target
    𝒚̂𝒕- output gap
    𝜺𝒊t - monetary policy rate shock
    𝜺𝒕𝒂𝒓t - 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.