Inflation, interest rate and output gap in the US economy: a vine copula modeling

Abstract

Purpose

The purpose of this paper is to investigate the relationship between inflation, interest rate, and output gap in the US economy in the post Second World War period, without assuming any structure nor imposing any restriction on that relationship.

Design/methodology/approach

The authors apply vine copula modeling to investigate asymmetry and tail behavior on both conditional and unconditional dependence among those variables. The dependence parameter is allowed to evolve over time according to a stochastic autoregressive processes. Additionally, a conditional expectation based on vine copula is used to analyze the conditional expectation of interest rate.

Findings

The results suggest that the joint distribution, both conditional and unconditional, of the interest rate and inflation is asymmetric to the left, while the pair interest rate and output gap have symmetrical distributions coupled with low persistence and high volatility. Besides the unquestionable evidence that the US monetary policy has been mostly focused on inflation stabilization, there is also indication of nonlinearity in the conditional expected interest rate and asymmetric behavior by the Federal Reserve in the long run.

Originality/value

The vine copula modeling allows for several forms of asymmetries and tail dependence, which is a flexible modeling strategy for multivariate distributions. Moreover, the conditional expectation implied by vine copulas is suitable to account for nonlinearity in the interest rate conditional on inflation and output gap.

Citation

Candido, O. and Divino, J.A. (2017), "Inflation, interest rate and output gap in the US economy: a vine copula modeling", Journal of Economic Studies, Vol. 44 No. 3, pp. 412-430. https://doi.org/10.1108/JES-12-2015-0231