Estimating the Monetary Policy Reaction Function for Taiwan: A VAR Model

This study examines Taiwan’s monetary policy reaction function based on an extended Taylor rule including the exchange rate, the stock price, and the lagged interest rate. The VAR model is employed to consider simultaneous relations among the endogenous variables. Two major monetary policy instruments - the discount rate and the collateral loan rate - are considered. The results show that within a 95% confidence interval, the discount rate or the collateral loan rate responds positively to a shock to the inflation gap and the stock price gap but does not react significantly to a shock to the output gap or the exchange-rate gap. Furthermore, except for the lagged interest rate, the inflation gap is more influential in explaining the variance of the interest rates than other endogenous variables, suggesting that the major focus of the monetary policy in Taiwan is to contain inflation.