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The Output Euler Equation and Real Interest Rate Regimes

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  • Pym Manopimoke

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.

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  • Pym Manopimoke, 2016. "The Output Euler Equation and Real Interest Rate Regimes," PIER Discussion Papers 33, Puey Ungphakorn Institute for Economic Research.
    • Handle: RePEc:pui:dpaper:33
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    More about this item

    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;
    All these keywords.

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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