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.
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.
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