The central bank
The monetary policy reaction function
The IS curve and choice of r
Empirical interlude
Analysis
The monetary policy reaction function It can be shown that minimisation of the loss function with respect to Y1 gives: Y1 − Ye Ye
=
−β(π1 − π T )
Given the PC curve that it faces, and its preferences, this relationship shows the central bank’s chosen combination of output and inflation. The negative sign is directly linked to the PC curve constraint: the only way that a central bank can reduce inflation is by depressing output. β measures the central bank’s aversion inflation: whatever the PC constraint, a very inflation averse (VIA) central bank always choose to depress output much more than a neutral bank in order to tame inflationary pressures more quickly. The central bank will guide the economy along the MRPF curve.