Traditional output dynamics: A structural perspective

Abstract

We provide theoretical underpinnings to the traditional IS curve by using the concept of basic and non-basic goods and services in the consumption basket. An extended version of this IS curve incorporates the effects of functional income distribution by appealing to rule-of-thumb behavior. An empirical analysis for both emerging and advanced economies shows that this IS curve does not suffer from the "IS puzzle," a weakness that affects its new Keynesian counterpart, when a measure of the nominal interest rate is used. The interest rate negatively and significantly affects output. Secondly, the second-order term typically specified in the output dynamics does not arise from structural consumption behavior. Thirdly, although we find significant rule-of-thumb behavior in that the labor share is statistically significant, optimal behavior dominates economies. Lastly, basics make up an overwhelming component of the consumption basket, which explains the sluggish response of output to shocks. The implication is that there is a need to extend the basic two-equation model into a 3-equation system by adding the dynamics of the labor share.