Monetary policy reaction function
Encyclopedia
The Monetary Policy Reaction Function (MPRF) is the upward-sloping relationship between the inflation rate
and the unemployment rate. When the inflation rate
rises, a central bank
wishing to fight inflation
will raise interest rates to reduce output and thus increase the unemployment rate.
The MPRF is a function of theTaylor Rule
, the IS curve, and Okun's Law
The MPRF has the equation:
u = u0 + Φ(π - πt)
Where Φ is a parameter that tells us how much unemployment rises when the central bank
raises the real interest rate
r because it thinks that inflation
is too high and needs to be reduced.
The Slope of the MPRF is:
1/Φ
The MPRF is used hand in hand with the Phillips Curve
to determine the effects of economic policy
. This framework illustrates equilibrium
levels of the unemployment rate and the inflation rate
in a sticky-price model.
Alternatively, in Ben Bernanke and Robert Frank's Principles of Economics textbook, the MPRF is a model of the Fed's interest rate behavior. In its most simple form, the MPRF is an upward-sloping relationship between the real interest rate and the inflation rate. The following is an example of an MPRF from the third edition of the textbook:
r = r* + g(π - π*)
r = target real interest rate (or actual 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
Of course, the MPRF above is just one example, and there are other examples (such as the Taylor Rule) that are more complex.
The following graph (from the Aplia Econ Blog) shows the simple MPRF with the real interest rate on the Y-axis and the inflation rate on the X-axis. Assume a 3% actual and long-run target inflation rate.
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...
and the unemployment rate. When the inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...
rises, a central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
wishing to fight inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
will raise interest rates to reduce output and thus increase the unemployment rate.
The MPRF is a function of theTaylor Rule
Taylor rule
In economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the...
, the IS curve, and Okun's Law
Okun's law
In economics, Okun's law is an empirically observed relationship relating unemployment to losses in a country's production first quantified by Arthur M. Okun. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP will be at an additional roughly 2% lower...
The MPRF has the equation:
u = u0 + Φ(π - πt)
Where Φ is a parameter that tells us how much unemployment rises when the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
raises the real interest rate
Real interest rate
The "real interest rate" is the rate of interest an investor 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 approximately the nominal interest rate minus the inflation rate...
r because it thinks that inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
is too high and needs to be reduced.
The Slope of the MPRF is:
1/Φ
The MPRF is used hand in hand with the Phillips Curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...
to determine the effects of economic policy
Economic policy
Economic policy refers to the actions that governments take in the economic field. It covers the systems for setting interest rates and government budget as well as the labor market, national ownership, and many other areas of government interventions into the economy.Such policies are often...
. This framework illustrates equilibrium
Underemployment equilibrium
In Keynesian economics, underemployment equilibrium refers to a situation with a persistent shortfall relative to full employment and potential output so that unemployment is higher than at the NAIRU or the "natural" rate of unemployment. This situation is not seen as solvable via laissez-faire...
levels of the unemployment rate and the inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...
in a sticky-price model.
Alternatively, in Ben Bernanke and Robert Frank's Principles of Economics textbook, the MPRF is a model of the Fed's interest rate behavior. In its most simple form, the MPRF is an upward-sloping relationship between the real interest rate and the inflation rate. The following is an example of an MPRF from the third edition of the textbook:
r = r* + g(π - π*)
r = target real interest rate (or actual 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
Of course, the MPRF above is just one example, and there are other examples (such as the Taylor Rule) that are more complex.
The following graph (from the Aplia Econ Blog) shows the simple MPRF with the real interest rate on the Y-axis and the inflation rate on the X-axis. Assume a 3% actual and long-run target inflation rate.