Monetary policy reaction function and external economic uncertainty: evidence from 30 selected countries

Abstract

A noteworthy feature in the monetary policy decision making is that interest rate can play a significant role in addressing economic uncertainty. Although the empirical studies on monetary policy reaction function routinely include the output gap and the inflation, not many studies take into account the exchange rate uncertainty and terms of trade uncertainty. To overcome this shortcoming, this paper examines the monetary policy reaction function by including the external economic uncertainty. Based on 30 selected countries, the estimation is relaxed by using the panel heterogeneous cointegration technique. The findings suggest that (i) the interest rate can serve as an important instrument for the central bank policy decision making to combat the economic uncertainty arising from output, inflation, exchange rate and terms of trade (TOT), and (ii) the economic uncertainty (i.e., output uncertainty, inflation uncertainty, exchange rate uncertainty and TOT uncertainty) can serve as a useful information for monetary policy action to avoid and/or mitigate a negative impact of uncertainty.

Keywords

• Monetary policy reaction
• External economic uncertainty
• Panel unit root tests
• Panel heterogeneous cointegration technique