Ricardian equivalence and positively sloped IS curve: (Dis)equilibrium insights

• Published in: Journal of economic asymmetries 2024-11, Vol.30, p.e00385, Article e00385
• Main Authors: Chrysanthopoulou, Xakousti, Sidiropoulos, Moise, Tsioutsios, Alexandros
• Format: Article
• Language: English
• Subjects: Determinacy; Dynamic IS curve; Dynamic stability; FCVAR; Limited asset market participation; Ricardian equivalence
• ISSN: 1703-4949
• DOI: 10.1016/j.jeca.2024.e00385

In the New-Keynesian model augmented with non-Ricardian households (breakdown of the Ricardian equivalence), the elasticity of aggregate demand to changes in real interest rate is linked non-linearly to the share of non-Ricardian households. Importantly, this dependence may result in an upward-sloping dynamic New-Keynesian IS curve. Using an extended fractionally cointegrated VAR model in a recursive framework, we empirically test this for the US from 1959 to 2024, finding a positive long-run relationship between consumption and interest rates from 1980 to 1992, and a negative one from 1993 onwards, with a stronger negative correlation after 2000. These results suggest shifts in asset market participation, altering equilibrium dynamics in the goods market. We analytically show that when non-Ricardian households surpass a certain threshold, output adjusts to excess supply rather than demand, imposing novel restrictions on the New-Keynesian Phillips curve to maintain equilibrium determinacy. These bounds on the New-Keynesian Phillips curve slope under varying inflation targeting rules offer a new perspective on monetary policy design.