Revisiting the interest rate puzzle

Abstract

This article makes a connection between Lucas' (1978) asset pricing model and the macroeconomic dynamics for some selected countries. Both the relative risk aversion and the impatience for postponing consumption by synthesizing the investor behaviour can help to understand some key macroeconomic issues across countries, such as the savings decision and the real interest rate. I find that the government consumption makes worse the so-called ‘equity premium-interest rate puzzle’. The first root of the quadratic function for explaining the real interest rate can produce this puzzle, but not the second root. Thus, Mehra and Prescott (1985) identified only one possible solution.

Notes

¹Source of data for the nominal interest rates and GDP deflator: International Financial Statistics, IFS/IMF. For each country, we estimate the real interest rates in the following way: (i) USA, nominal interest rate of Treasury Bill 3 months minus inflation (GDP deflator); (ii) Brazil, nominal interest rate of money market minus inflation (GDP deflator); (iii) Chile, nominal interest rate of money market minus inflation (GDP deflator); (iv) China, nominal interest rate of Interbank Deposit Certificate (CDI) minus inflation (deflator do PIB); (v) India, nominal interest rate of money market minus inflation (GDP deflator); (vi) Mexico, nominal interest rate of central bank fund minus inflation (GDP deflator); and (vii) South Korea, nominal interest rate of money market minus inflation (GDP deflator).

²Source of data for consumption (final consumption and household consumption) and GDP: World Bank National Accounts Data; WDI – World Development Indicators.

³ Figure 2 plots Equation 2(2) assuming both β = 0.99 and the data of each country: real interest rate (expectation) and final consumption (expectation, variance and variance of conditional expectation) that are reported in Table 5.