Abstract
A notable feature in many mainstream economic theories and empirical works of literature has been emphasized the conventional development in the domestic economic factors in dealing with monetary policy in both positive and normative approaches. However, external economic factors consist of potentially valuable information, such as the exchange rate and terms of trade, that cannot simply be ignored. To address this limitation, this study examines the monetary policy reaction function in an open economic model in both positive and normative approaches that encompasses the domestic and external factors, namely the inflation, the output gap, the exchange rate and the terms of trade. The empirical validity is obtained by using a sample of ASEAN-3 countries. Both the positive and normative approaches adopt the generalized method of moments and the grid search method, respectively. The findings deliver some policy implications; monetary policy via interest rate remains an important strategy in absorbing shocks from domestic and external factors, and the central bank should include important factors, namely the inflation, the output gap, the exchange rate and the terms of trade, in its monetary policy decision making that eventually help to attain the best economic outcomes.
Highlights
S study uses the the grid search algorithm procedure proposed by Gan (2014)
The aim of this study is to examine the monetary policy reaction function in both positive and normative approaches that encompasses the domestic and external factors, namely the inflation, the output gap, the exchange rate and the terms of trade (TOT); the positive approach is to determine ‘by how and what’ about the monetary policy reaction function, whereas the normative approach is to determine ‘what ought to’ be about the best monetary policy reaction function concerning the goals of the central bank
The estimated parameters from the positive analysis are calibrated by using the grid search algorithm procedure to compute the best monetary policy reaction function
Summary
S study uses the the grid search algorithm procedure proposed by Gan (2014). The normative analysis of the optimal monetary policy reaction function is executed by calibrating the open economic model by using the GMM estimates for benchmark parameters; the results of the GMM estimates may determine the relationship among the variables of the monetary policy reaction function, i.e., the positive analysis. The GMM is a system estimates that can examine a structural economic model. To avoid a monotonous discussion of GMM estimates on a structural economic model, this study follows the method of the system GMM estimates proposed by Gan (2018). Prior to the testing of the monetary policy reaction function in both the positive and normative approaches, this study examines the level of stationarity for dataset
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