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posted on 27 September 2015

Calculating The Natural Rate Of Interest: A Comparison Of Two Alternative Approaches

from the Richmond Fed

-- this post authored by Thomas A. Lubik and Christian Matthes

The natural rate of interest is a key concept in monetary economics because its level relative to the real rate of interest allows economists to assess the stance of monetary policy. However, the natural rate cannot be observed; it must be calculated using identifying assumptions.

This Economic Brief compares the popular Laubach-Williams approach to calculating the natural rate with an alternative method that imposes fewer theoretical restrictions. Both approaches indicate that the natural rate has been above the real rate for a long time.

The natural rate of interest is one of the key concepts for understanding and interpreting macroeconomic relationships and the effects of monetary policy. Its modern usage dates back to the Swedish economist Knut Wicksell, who in 1898 defined it as the interest rate that is compatible with a stable price level.1 An increase in the interest rate above its natural rate contracts economic activity and leads to lower prices, while a decline relative to the natural rate has the opposite effect. In Wicksell's view, equality of a market interest rate with its natural counterpart therefore guarantees price and economic stability.

A century later, Columbia University economist Michael Woodford brought renewed attention to the concept of the natural rate and connected it with modern macroeconomic thought.2 He demonstrated how a modern New Keynesian framework, with intertemporally optimizing and forward-looking consumers and firms that constantly react to economic shocks, gives rise to a natural rate of interest akin to Wicksell's original concept. Woodford's innovation was to show how the natural rate relates to economic fundamentals such as productivity shocks or changes in consumers' preferences. Moreover, an inflation-targeting central bank can steer the economy toward the natural rate and price stability by conducting policy through the application of a Taylor rule, which links the policy rate to measures of economic activity and prices.

[click on image below to continue reading]

Source: https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_brief/2015/pdf/eb_15-10.pdf

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