Monetary policy reaction function

Monetary Policy Reaction Function

Monetary policy reaction function

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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 = u<sub>0</sub> + 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.

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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.<br /><br /><br /><br />Alternatively, in Ben Bernanke and Robert Frank's <i>Principles of Economics</i> 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:<br /><br />

r = r* + g(π - π*)

r = target real interest rate (or actual real interest rate)<br />r* = long-run target for the real interest rate<br />g =...
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