Monetary policy, in general, refers to those steps taken by
the Central Bank to achieve such broader objectives of the economy as
growth, employment, external balance and price stability through changes
in the money supply, interest rates and credit policies. The money
supply thus created by the Central Bank should be in response to the
changes in key macroeconomic target variables such as GNP, balance of
payments, inflation, internal debt and unemployment. Indeed, a properly
estimated monetary policy reaction function can provide useful
information regarding such matters as to whether the Central Bank, in
fact, has been systematically accommodating to the changes in the target
variables. The reaction function can also provide insight into the
question as to what should be the relevant indicators of the monetary
policy. In addition, as argued by Havrilesky (1967), it may also play a
crucial role in the formulation of long-term monetary policy strategy.
The other important consideration in the development of a monetary
policy reaction function pertains to the endogeneity of the monetary
policy. As pointed out by Goldfeld and Blinder (1972), if a policy
variable responds to the lagged (or expected) target values, then
considering such a policy variable as exogenous would not only introduce
the problem of misspecification but will also produce serious biases in
the parameters estimated from those models. In particular, if the
monetary policy variable happens to be strongly influenced by target
variables, then the standard result of the relative effectiveness of the
monetary policy vis-a-vis fiscal policy can be questionable on the
grounds of reverse causation problem.
