Abstract
Extending the original Taylor rule and applying the VAR model, the author finds that the federal funds rate (FFR) responds positively to a shock to the output gap, the inflation gap, the long-term interest rate, or the lagged FFR, and it reacts negatively to a shock to the unemployment rate gap or the exchange rate. The response of FFR to stock prices is insignificant at the 5% level. The long-term rate can explain up to 41.3% or 46.1% of the variation in FFR, depending on the model considered. The exchange rate can explain up to 8.5% or 12.3% of the variance, depending on the model considered. The output gap can explain up to 26.6% of FFR variance. The unemployment rate gap can explain up to 26.8% of the variation in FFR. Because FFR responds to a shock to the output gap and the unemployment rate gap in a similar manner, both may be considered in conducting monetary policy. The more explanatory power of the long-term interest rate than the inflation gap may suggest that both need to be taken into consideration in the Taylor rule.
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