Modeling an Extended Taylor Type Equation in Indian Environment

The objective of the paper is to examine applicability of Taylor type rule in current Indian economic environment. India has gradually slackened its control on several macroeconomic variables and allowed influence of market forces in many areas. In this scenario, we tried to examine an extended Taylor type equation involving interest rates, output gap, inflation gap, foreign exchanges rate, stock index and foreign investments in capital markets. We found a cointegrating relationship among these variables and delineated a vector error correction model following Johansen’s method. It was also confirmed that inclusion of additional variables improved performance of the model.