Mortgage spread and the IS puzzle: Theory and Evidence

Abstract

In this investigation, we specify and estimate different models of the IS curve for five advanced economies and five emerging market economies to explore the impact of the risk premium on stimulating aggregate demand and resolving the IS puzzle. Economic theory indicates that interest rates should have a negative effect on output. However, empirically, our findings reveal that the OLS estimates of the standard backward-looking IS curve and the GMM estimates of the standard forward-looking IS curve produce a real interest rate coefficient that deviates from theoretical expectations, a phenomenon termed the “IS puzzle.” To tackle the IS puzzle, we expand these baselines IS curves by incorporating a risk premium represented by either the mortgage or term spread and the real effective exchange rate. Our analysis indicates that the enhanced forward-looking IS curve outcomes surpass those of the extended backward-looking IS curve; yet the IS puzzle persists in certain countries. Furthermore, we observe that the mortgage spread significantly influences output in some nations and provides a better explanation for output fluctuations compared to the term spread. These findings imply that the extended forward-looking IS curve holds relevance for monetary policy analysis, emphasizing the importance of considering the mortgage spread in policymaking decisions. In conclusion, we advocate for the development of more comprehensive specifications of the IS curves to effectively address the IS puzzle.