Monetary Policy Reaction Function in Positive and Normative Approaches: Evidence from ASEAN-3

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.