Monetary policy in the g3 model

The central bank reaction function is represented in the g3 model by the relationship between the nominal interest rate and expected inflation. Its equation is based on a modified Taylor rule. Formally, the central bank reaction function is expressed as

it = ρit-1 + ( 1 - ρ ) ( iteq + ψ πt+4 ) + εt

where it is the monetary policy nominal interest rate, ρ is the interest rate smoothing parameter, iteq is the equilibrium monetary policy nominal interest rate, which is the sum of the equilibrium real interest rate and model-consistent inflation expectations, ψ is the weight of the deviation of inflation from the target, πt+4 is the expected deviation of inflation from the inflation target, and εt is the monetary policy shock. The parameters of the rule were calibrated to ensure that monetary policy has a stabilising effect. Given the forward-looking nature of the reaction function, this functional form cannot be estimated by means of single-equation econometric methods based on historical data.

The reaction function determines the interest rates with regard to the deviation of expected monetary-policy relevant inflation from the inflation target at the monetary policy horizon, which is set to four quarters in the g3 model. The estimate for inflation at the monetary policy horizon reflects all macroeconomic variables entering the model.