Identification Robust Empirical Evidence on the Open Economy IS‐Curve
| Published date | 01 April 2023 |
| Author | Qazi Haque,Leandro M. Magnusson |
| Date | 01 April 2023 |
| DOI | http://doi.org/10.1111/obes.12526 |
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 85, 2 (2023) 0305-9049
doi: 10.1111/obes.12526
Identification Robust Empirical Evidence
on the Open Economy IS-Curve
QAZI HAQUE† and LEANDRO M. MAGNUSSON‡
†CAMA and School of Economics and Public Policy, The University of Adelaide, Adelaide, SA,
Australia (e-mail: leandro.magnusson@uwa.edu.au)
‡Department of Economics, Business School, The University of Western Australia, Crawley, WA,
Australia
Abstract
Existing empirical evidence on the Euler equation based on closed economy models
suggests low responsiveness of aggregate consumption to changes in interest rates. We
incorporate open economy features and consider extensions that include habit formation
and hand-to-mouth consumers. For several open economies and applying econometric
methods that are robust to weak instruments and structural changes, we continue to find
low values for the elasticity of intertemporal substitution, implying a small effect of
real interest rate changes on aggregate income. In some countries, structural changes are
informative for identification, but otherwise aggregate data provide limited information
to learn about IS-curve specifications.
I. Introduction
The New Keynesian framework has become a workhorse model for the analyses of
monetary policy.1The model essentially reduces the economy to three major elements:
a central bank that seeks to stabilize the output gap and to keep inflation as close to a
target level as possible, a Phillips curve that expresses how a deviation of output from its
potential level drives inflation dynamics, and an IS-curve that represents the intertemporal
Euler equation. The IS-curve posits an inverse relationship between output and the real
interest rate. Therefore, it provides an important channel for monetary policy to influence
aggregate demand in standard dynamic stochastic general equilibrium (DSGE) models:
consumers are assumed to substitute towards spending more when monetary policy lowers
interest rates, and towards saving more when monetary policy brings interest rates up.
JEL Classification numbers: C1, C2, E1, F4.
We would like to thank the Editor Francesco Zanetti and three anonymous referees for their constructive feedback.
We also thank Guido Ascari, Fabio Canova, Efrem Castelnuovo, Tim Robinson, Yong Song, Mark Weder and
seminar participants at The University of Melbourne for very helpful discussions. The authors acknowledge
generous support from the Australian Research Council under the grant DP170100697. Open access publishing
facilitated by The University of Western Australia, as part of the Wiley - The University of Western Australia
agreement via the Council of Australian University Librarians.
1See Goodfriend and King (1997), Clarida, Gal´
ı and Gertler (1999), Woodford (2003)andGal
´
ı, (2008) for exposition
of the New Keynesian model.
345
©2022 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and John Wiley & Sons Ltd.
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and
distribution in any medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.
346 Bulletin
The magnitude and direction of this effect are captured by the elasticity of intertemporal
substitution (EIS), which is ‘‘a parameter of central importance in macroeconomics and
finance’’, see Yogo (2004).
In this paper, we investigate open economy IS-curve models using limited-information
generalized method of moments (GMM) that are robust to the problem of weak
identification and parameter instability.2The main motivation of our work is to provide
systematic evidence on the IS-curve model for open economies to various specifications of
the model studied in the literature (and surveyed in section II) and report the findings in a
unifying framework. We investigate extensions of the IS-curve based on the open economy
framework of Clarida, Gal´
ı and Gertler (2002)andGal
´
ı and Monacelli (2005). These
extensions include models with (i)habit formation in consumption as in Dennis (2009)and
(ii)hand-to-mouth consumers (HTMC) as in Bilbiie and Straub (2012). The conventional
IS-curve is purely forward-looking. The inclusion of habit formation in consumption,
which is now a standard feature in macroeconomic DSGE models, for example, see
Christiano, Eichenbaum and Evans (2005) and Smets and Wouters (2007), generates
inertia in consumption dynamics, thereby lowering the responsiveness of consumption to
interest rate changes. The introduction of HTMC also decreases this responsiveness since
consumers who do not have access to financial markets simply consume their income, for
example, see Campbell and Mankiw (1989), Bilbiie (2008) and Bilbiie and Straub (2012).
All the open economy IS-curve models considered in this paper nest the closed economy
as a special case.
Moreover, similar studies for the New Keynesian Phillips Curve (Kleibergen and
Mavroeidis, 2009; Magnusson and Mavroeidis, 2014), the Taylor rule (Mavroeidis, 2010)
and the (closed economy) Euler equation model (Yogo, 2004; Ascari, Magnusson and
Mavroeidis, 2021) demonstrate the importance of employing econometric methods that
are robust to the weak-instrument problem. Hence, we test the IS-curve specifications
using methods proposed by Stock and Wright (2000), Kleibergen (2005) and Magnusson
and Mavroeidis (2014) that are robust to weak identification. The method of Magnusson
and Mavroeidis (2014) can also be interpreted as a parameter stability test robust to
weak instruments and therefore can provide evidence on structural breaks in the IS-
curve. We also apply a more recently developed method by Mikusheva (2021), which
explores information from many potential instruments available for inference using a
split-sample technique. We test the IS-curve specifications using these methods for a set
of six countries fitting the features of open economies: Australia, Canada, New Zealand,
Sweden, Switzerland and the United Kingdom. To the best of our knowledge, we are
the first ones to empirically study open economy IS-curves using identification robust
methods. Our findings read as follows.
First, the aggregate EIS, which measures the responsiveness of output to interest
rate changes stemming from intertemporal substitution, is well identified and low in all
countries. Confidence sets are mostly tight and include zero in all cases. This result is
robust to weak identification and possible structural breaks. Several variants of both the
closed and open economy models for the countries in our dataset point to low values of
2By focusing on limited-information methods, we refrain from imposing the entire DSGE structure that can lead to
extraneous model misspecification.
©2022 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and John Wiley & Sons Ltd.
Get this document and AI-powered insights with a free trial of vLex and Vincent AI
Get Started for FreeStart Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting