Monetary Policy Index and Policy Reaction Function

Abstract

Endogenity and inconsistency are two problems that arise when the conventional money market variables, such as money supply, monetary base, and non-borrowed reserve and short interest rates, are used as the proxy for monetary policy. This paper uses the narrative approach to build up a monetary policy index. This index is then employed to examine the central bank reaction function, of which linear and nonlinear forms are considered. Our results show that the monetary policy reacts differently to the inflation rate and real output when economic conditions are different. Strong responses are discovered when the inflation rate and output are above their corresponding tolerance level of the central bank.