Modeling which Factors Impact Interest Rates

Abstract

The Taylor (1993) rule for determining interest rates isgeneralized to account for three additional variables: The moneysupply, money velocity, and the unemployment rate. Thus, five pa-rameters, i.e. weights assigned to the deviation in the inflation rate,the deviation in real GDP (Gross Domestic Product), the deviationin money supply, the deviation in the money velocity, and the de-viation in unemployment rate, are introduced and estimated. Thearticle explores and tests various combinations of the Taylor rule, theQuantity Equation (Friedman, 1970), and the Phillips (1958) curve.The monthly US January 1, 1959 to March 31, 2022 data are adoptedto test the optimal parameter values. Estimating the parameters withthe least squares method gives better results than the Taylor rule.The optimal parameter values involve a relatively high weight to thedeviation in unemployment rate, and moderate weights are assignedto the deviation in the inflation rate, the deviation in real GDP, thedeviation in money supply, and the deviation in the money velocity.The corresponding sum of squares decreases by 42.95% when com-pared with the Taylor rule.