For example, for the ECB, many papers have estimated different versions of the monetary policy reaction function. Is it because different authors believe differently about how the central bank sets its policy rate? And hence we cannot really say one estimated policy reaction function is better than the other?
For example, one author may say, let me see how the central bank reacts to the inflation gap (x1) and output gap (x2). Then another author would say, let me see how the central bank reacts to the inflation gap (x1), output gap (x2), and exchange rate (x3). Then some author would add commodity price; another would add, say, deficits; and another would add, say, trade balance; and another would add, say, the lag of the policy rate…and the list could go on. But here, it seems these are from a purely empirical perspective, right?
And the choice of the variables in the reaction function could also be based solely on theory? For example, the monetary policy rule with only the inflation and output gap requires that the coefficient of the inflation gap is more than 1 in new Keynesian models. So, for example, I can check that for some country A and then use that info for further analysis, right? Then, someone may ask, why didn’t you include the exchange rate, commodity price, trade balance, government deficit, some lags, etc., in the reaction function? My answer is they unimportant for the theory and the analysis I am considering. A fair answer, right? Like, the theory I have adopted is restricting the choice of the variables in the reaction function. That seems to be a fair answer to me, but I would kindly also like to know what others think, if I may ask.
I even heard arguments like the output gap might capture other variables like the deficit, trade balance, etc. because even if the central bank looks at the deficit data, for example, their focus is how that affects the inflation and output gap at the end of the day.
Maybe there are no right or wrong monetary policy reaction functions, but different monetary policy reaction functions for different questions (based on the goal of the author). And that is why we have so many of them? Or we have so many of them because we are looking for the correct one? Thanks for any answer. Trying to transition from student to researcher, but some many arguments and info out there…:). May you help if you can, if my thoughts above are correct or make sense? Thus, why so many different policy reaction functions Thank you…!!