The reaction function of the Central Bank is also called the reaction function of monetary policy.
The reaction function can be defined, in general, as the functional relationship that describes how the central bank adjusts its policy instruments such as interest rate or some monetary aggregate, in response to changes in target variables as inflation, production and exchange. Defined
lines above, the reaction function of monetary policy, it becomes a tool that shows how a central bank will behave in future similar to as it has in the past (Trend), you can also predict policy actions internal or external shocks to the economy. Thus, it can assess the current monetary policy, as well as projecting the evolution of the economy to shocks (shocks).
years ago, has tried to analyze this issue, but is not it more relevant and objectivity gained from research by John Taylor, whose simple rules have become a sort of policy recommendation, although there are different approaches on the same subject. In Monetary Policy, said of a simple rule, which is one that allows the monetary authority (Bank Central) to determine an appropriate level for interest rate depending on the behavior of a set of target variables.
John Taylor in 1993, proposes a rule that describes the behavior of the interest rate the U.S. economy (USA), in relation to the goal it has set the Federal Reserve:
i = 2 + ð + 0.5 (y - y *) + 0.5 (d - 2), where we have:
i = interest rate federal funds
ð = annual inflation rate (4 quarters)
y - y * = gap between real output (y) and potential (y *)
interrelated indicators of inflation and the output gap shows that the Federal Reserve, seeking a goal of sustained growth as well as one of low inflation and above all stable, showing its contractionary, where the interest rate remains relatively high, when inflation is above its goal or it also occurs when the level of the economy is on the level of full employment, so the goal is to keep interest rates at 2% and prevent inflation from the lead to one extreme or another.
After Taylor studies, many other economists have proposed rules derived, where smoothing methods are introduced to the relationship between the variables, other models introduced inflation expectations, and other models treat the Taylor rule as a rule Suboptimal, optimal development of a new rule that includes the effects of international market (open economy) and other international monetary conditions, example is the work of Lawrence Ball ("Policy Rules for Open Economies" - 1999).
central banks use as a method of setting goals ( Inflation Targeting ), the Taylor rule, and, if the current inflation rate is expected or above the preset target, the central bank as attributable to two variables: an independent exogenous demand and the level GDP growth above its potential growth (which may be due to an excess of demand).
Then, the reaction function of monetary policy, increases in the face of increasing inflation, is to raise real interest rates, this means, raise the nominal interest rate above the expected inflation.
Thus, monetary policy was temporarily forward (forward), against the government's reaction to inflation (through the Ministry of Economy and Finance) with a lag, for reasons mainly institutional and social policy issues.
monetary policy rule relates then the variation of the Product for the growth of inflation.
We (in the short term) written as follows:
[(y - y *) / y *] = & (ð - ð t)
Where & = function relates both variations .
This curve is also known as quasi-supply curve, the acceleration of inflation theory, which comes from a modified Phillips curve in the short term.
This is true under the conditions of wage rigidity, since these are not enough variations to changes in inflation and unemployment occurs in the short term, obviously this situation does not allow real product growth.
