The Output Euler Equation and Real Interest Rate Regimes

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 this result. Based on a joint specification for the OEE and the real interest rate in an unobserved components model framework with Markov-switching parameters, the means, variances, and degrees of persistence of the real interest rate are different for the periods 1966–1980, 1980–1985, and 1985–2015. Once these regime changes are taken into account, the EIS estimate is 0.1 and no longer statistically insignificant. This finding is robust to alternative measures of the output gap as well as different specifications for the natural real interest rate.