Advanced Search
MyIDEAS: Login

Which Interest Rate Should We Use In The Is Curve?

Contents:

Author Info

  • John J. Heim

    ()
    (Department of Economics, Rensselaer Polytechnic Institute, Troy, NY 12180-3590, USA)

Abstract

Do interest rates effect investment and the GDP? If so, which ones, and by how much? Research on this topic over 5 decades has produced conflicting results. Yet, this question is of critical importance to the viability of Keynesian macroeconomics. This paper attempts to explain why results have been conflicting. It also attempts to determine with some finality which rate(s), if any, are related to GDP through the standard Keynesian mechanism: the IS curve. The paper tests exhaustively (1) a variety of real and nominal rates, (2) different hypotheses about how businesses calculate “real” interest rates (3) how the number of lags used affects results, (4) whether small sample size inherent in annual time series data adversely affects results, and (5) whether lack of hetroskedasticity and autocorrelation controls in earlier studies influenced their findings. This paper concludes only the real prime or Federal funds rates, lagged two years and the nominal current mortgage rate are significantly related to variation in the GDP, and running the prime rate alone picks up most of the variation in both. The prime rate was found to be twice as important as the mortgage rate. It also finds relatively small size (40 observation) annual data sets do not lead to problems achieving statistical significance, at least in simple IS curve models. It also finds that post - 1980 White and Newey - West correction methods for hetroskedasticity make it far more likely that any of a wide variety of interest rates and lags will be found statistically significant than was the case in earlier studies, but that correcting for multicollinearity between rates again leaves only the real prime and Federal funds rate lagged two periods and perhaps the current nominal mortgage rate significant. The effect of changes in the prime rate and mortgage rates on the GDP, though systematic, appears to be small, implying the IS curve may be nearly vertical and the Fed’s interest rate policy of little significance unless rate changes are draconian. We estimate that even a five percentage - point change in the real Federal funds and prime rates changes GDP only 2.4%, and employment only 1.2% maximally (using Okun’s law). Other findings were that nominal interest rates deflated by adaptive expectations models of inflation using the past two year’s inflation seem to best describe how businesses calculate real rates. Rational expectations models were least successful. Other rates examined include the ten year treasury rate, the Aaa and Baa corporate rates. They were seldom found statistically significant, but the mortgage rate’s estimated marginal effect seems to also capture these rates’ effect on the economy.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.economics.rpi.edu/workingpapers/rpi0713.pdf
Download Restriction: no

Bibliographic Info

Paper provided by Rensselaer Polytechnic Institute, Department of Economics in its series Rensselaer Working Papers in Economics with number 0713.

as in new window
Length:
Date of creation: Aug 2007
Date of revision:
Handle: RePEc:rpi:rpiwpe:0713

Contact details of provider:
Email:
Web page: http://www.economics.rpi.edu/
More information through EDIRC

Related research

Keywords:

Find related papers by JEL classification:

This paper has been announced in the following NEP Reports:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Bivin, David G, 1986. "Inventories and Interest Rates: A Critique of the Buffer Stock Model," American Economic Review, American Economic Association, vol. 76(1), pages 168-76, March.
Full references (including those not matched with items on IDEAS)

Citations

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:rpi:rpiwpe:0713. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (John Heim) The email address of this maintainer does not seem to be valid anymore. Please ask John Heim to update the entry or send us the correct address.

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.