The Output Euler Equation and Real Interest Rate Regimes

Pym Manopimoke

No 33, PIER Discussion Papers from Puey Ungphakorn Institute for Economic Research

Abstract: Output Euler equations (OEE) for the US deliver slope estimates that are not significantly different from zero. This finding is counterintuitive as it implies a zero elasticity of intertemporal substitution (EIS) and aggregate demand movements that are nonresponsive to the short-term real interest rate. This paper shows that failure to account for regime changes in the dynamics of the real interest rate is responsible for the zero EIS result. In doing so, an empirical investigation is carried out based on an unobserved components framework with Markov-switching parameters that models the underlying process for the real interest rate jointly with the OEE. According to the estimation results, the ex-post real interest rate is a highly persistent process with means, variances and degrees of persistence that are different for the periods 1966–1980, 1980–1985, and 1985–2015. Once these changes in real interest rate behavior are taken into account, estimates for the EIS are 0.1 and are no longer statistically insignificant. This finding is robust to various measures of the output gap as well as alternative specifications for the time-varying natural real rate.

Keywords: Aggregate Demand; Output Euler Equation; Markov-Switching; Monetary Policy; New Keynesian IS Curve; Real Interest Rate; Persistence; Unobserved Components Model; Elasticity of Intertemporal Substitution (search for similar items in EconPapers)
JEL-codes: E12 E32 E43 E52 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2016-06
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