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Published: Comovements between Output and Interest Rates (JEDC, 2010)

posted Jan 26, 2010, 6:50 AM by Elmar Mertens   [ updated Oct 7, 2011, 7:08 PM ]
My first thesis chapter revisited the output-interest rate puzzle of King and Watson (1996, REStat), who found it hard to match the comovements between output and interest rates (real and nominal) with a wide array of DSGE models.

My thesis already found that conditional on shocks to technology and monetary policy, comovements were in line with standard models, where different shocks induce different comomvents.

In a revised version, I have added now more shocks and also did some sub-sample analysis, where I found that the puzzling anti-cyclical behavior of the real rate, vanishes over the Great Moderation (see picture below, click to enlarge). Interestingly, this is mostly due to a change in the composition of shocks hitting the economy, and less to a change in the conditional comovements induced by each shock.

In terms of additional shocks, I found news shocks quite important to explain the comovements unexplained by technology and monetary policy. The anticylical behavior of the real rate, seems to stem from random walk shocks to inflation, occuring during the Great Inflation. In ongoing work, I intend to investigate this further by extending the stochastic volatility models of inflations used by Stock and Watson (2007, JMCB) and Cogley, Primiceri and Sargent (2010, AEJ Macro).

The paper has been published at the Journal of Economic Dynamics and Control and the manuscript can be found under my publications.