Modelling Monetary Policy Reaction Functions

Abstract

This paper considers how monetary policy is modelled currently, with particular reference to the Reserve Bank of New Zealand’s dynamic stochastic general equilibrium model: Kiwi Inflation Targeting Technology (K.I.T.T.). By considering the role and objectives of monetary policy along with its dynamic effects, it is suggested that monetary policy might better be modelled using micro-foundations, where the path of monetary policy is determined by an optimising central bank. In the context of the New Zealand economy, the monetary authority’s optimisation problem is postulated and developed. To conclude, an alternative monetary policy reaction function is suggested for use in K.I.T.T..