The IS curve and the transmission of monetary policy: is there a puzzle?

In this paper, the performance of the New Keynesian IS curve for the G7 countries is assessed. It is found that there is an IS puzzle for both the purely backward-looking as well as for the forward-looking IS curve. The real interest rate does not have a significantly negative effect on the output gap. Based on an extended specification of the IS curve, also including asset prices and monetary aggregates, a significantly negative interest rate effect on aggregate demand is found for all countries. This finding suggests that a richer specification of the IS curve in empirical work may be necessary in order to obtain an unbiased estimate of the effect of monetary policy on aggregate demand.

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