An Analysis of the Real Interest Rate and Monetary Policy under Regime Shifts
Keywords:
Nonstationary series, real interest rate, unit root, stochastic process, vector autoregressions, monetary policyAbstract
The real interest rate plays a central role in macroeconomic theory and the transmission mechanism of monetary policy. This paper extends Garcia and Perron’s (1996) time series analysis of the U.S. real interest rate to better understand its dynamics over the postwar period.
Using a three-state Markov Switching model and a Hamilton filter estimation approach, the means and variances of the real interest rate series are found to be different over the time periods 1954-1973, 1973-1981, 1981-1986, 1986-2002, and 2002-2006. To examine whether a change in the conduct of monetary policy might have been the major driving force behind these shifts in the real interest rate series, a three-variable recursive Vector Autoregression (VAR) model comprising of the unemployment rate, price inflation and the short term interest rate is used to examine the nature of monetary policy over the five different time periods. Based on the impulse response analyses of the VAR, we cannot conclude that monetary policy is the main determinant behind real interest rate fluctuations. As shifts in preferences and technology have been suggested to affect the dynamics of the real interest rate as well, a joint investigation of the real interest rate, monetary policy, and output trend growth rate might be able to better explain the causes for regime shifts in the U.S. real interest rate.
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