Question

Suppose an economy is experiencing higher inflation rate as well as a recessionary gap. Using the policy reaction function, explain whether the Reserve bank will increase or decrease the interest rate?

Answer 1

Monetary policy reaction function looks like the following

i = i_t + a(y – y_t) + b(? – ?_t)

In the above i = actual interest rate

i_t = Target interest rate

y = Actual output

y_t = Potential output

? = Actual inflation

?_t = Target inflation

From the above it can be said that the reaction of the Reserve Bank to the existence of high inflation and recessionary gap depends the relative strength of the two. This is because if the bank tries to tackle recessionary gap through expansionary monetary policy then inflation will further increase due to increased demand. On the other hand, if the bank adopts contractionary monetary policy to tackle inflation then the recessionary gap will increase due to reduced demand.

So, if the strength of the recessionary gap (difference between actual and potential output) is stronger then the inflationary pressure then interest rate will decline. On the other hand, if the strength of inflationary pressure is higher than the recessionary gap then the interest rate will increase.