Estimating Taylor rules in a credit channel environment

There is a general belief that policymakers take into account credit channel conditions when deciding monetary policy. However, literature lacks evidence on the specific role of credit channel in monetary policymaking. This paper estimates an extended version of the Taylor rule by incorporating credit channel variables explicitly. In particular, net worth capital ratio, bankruptcy cost and default rate are included in the model, motivated by the model of Bernanke, Gertler, and Gilchrist (1999). Among the added credit channel variables, net worth capital ratio is both statistically and economically significant during 1989–2008. We test the potential misspecification of the estimated model by allowing the serial correlation of errors arising from the omitted variables to enter the Taylor rule specification. This experiment confirms that our main findings are robust to such model misspecifications.