# Monetary policy rules: Constructing a Monetary Policy Rule

Monetary policy rules

Monetary policy rules: Exchange Rate and Monetary Policy Rules

An MPR is an algebraic representation of a policy rule that stipulates how an instrument ofmonetary policy will react to key economic variables and therefore achieve a specific policy objective. There are three main components to the MPR. The first is the policy instrument. This is the variable that the policymaker adjusts to affect its monetary policy. In the Taylor rule, the MPR is a short-term interest rate.

In the subsequent literature onMPRs, economists have investigated the use of other possible instruments of policy. These include the exchange rate, a combination of the interest rate and the exchange rate (a monetary conditions index, or MCI), and even amonetary aggregate such as themonetary base, or M2. Whichever one is used, the instrument is essential for two reasons: it represents the policy lever and therefore must be subject to the policymaker’s control, and it must be able to influence economic activity to the extent that it satisfies the policy objectives.

The second component of an MPR is the set of variables to which the policy instrument responds. These variables convey information about the stance of monetary policy and signal how the instrument ought to react so that the policy targets aremet. In the basic Taylor rule, the variables to be included are the deviation of inflation from a preannounced target and the deviation of output from a long-run value designed to represent full employment. Under this specification, the Taylor rule essentially implies that the inflation and output deviations contain sufficient information about the stance of monetary policy to adequately drive interest rate movements.

Although not explicitly stated in the rule, the third component of anMPR is the policy regime that it is supposed to represent. The monetary policy regime most commonly pursued with MPRs is inflation targeting.As such, the boundaries of theMPR reflect how the instrument should react to the right-handside variables in a manner that achieves the stated policy.

But how does one link the policy objective to the MPR? The answer is through a statement of central bank objectives usually depicted by a central bank loss function. The loss function is an algebraic representation of the policymaker’s objectives and will typically detail the variables that the central bank is interested in targeting. If there are multiple objectives, the weight that the central bank attributes to each objective becomes important. The minimization of the loss function subject to the constraints imposed by a macroeconomic model will yield an MPR.

The MPR emerging from this minimization exercise is known as an optimal MPR one that is derived froman explicit policy objective. The Taylor rule itself is an example of a simple MPR, one where the rule is specified without reference to explicit objectives. In this instance, the variables captured by theMPRreflect the policy objectives. For example, if the simpleMPR contains expressions for output and inflation deviations, then it is assumed that these are the objectives of policy regardless of the model used to depict themacroeconomy.Under an optimal rule, the variables that appear on the right-hand side may not actually be policy objectives they may simply be variables that appear as part of themodel used for optimization. Herein lies the difference between simple and optimal MPRs. Optimal MPRs are highly dependent on the model used to derive the rule but are explicitly reflective of the actual policy preferences of the central bank. Simple MPRs are imposed on amacroeconomicmodel and, as such,do not explicitly reflect central bank policy preferences, but are likely to be robust across many model specifications.