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Atheoretical and Theory-Based Approaches to the Natural Equilibrium Real Interest Rate

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Abstract

Recent theoretical developments and practical monetary policy concerns have revived interest on the concept of a “natural” equilibrium real interest rate. The natural real interest rate is potentially an important concept for monetary policy makers. The observable market real interest rate and the natural real rate may deviate and the resulting gap can be used to evaluate the stance of monetary policy. A number of diverse empirical approximations to the natural rate exist causing a great deal of uncertainty about its value and concern about its applicability among central bankers. In this paper, we first examine the notion of the natural rate in view of the different interpretations that have been attached to the — unobservable — natural real interest rate and we summarize and critically evaluate the existing approaches for quantifying it. We then use a dynamic stochastic general equilibrium framework to obtain a theory-based measure of the natural interest rate in the US that is time varying.

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Notes

  1. 1. See, for example, ECB [2004].

  2. 2. For example, Arestis and Chortareas [2006] show how changes in the policymakers’ perceptions about the equilibrium real interest rate in the euro area may affect the ability of Taylor rule to track down the actual ECB behavior.

  3. 3. Similar values are assigned: to the discount factor by Cooley and Prescott [1995], King et al. [1988], and Fuhrer [2000]; to the labor share by Campbell [1994] and Cooley and Prescott [1995]; to the depreciation rate by Campbell [1994], King et al. [1988]; and to the AR(1) parameter of the technology shock by Campbell [1994], Cooley and Prescott [1995], and McCallum and Nelson [2000].

  4. 4. For example, see Casares and McCallum [2000].

  5. 5. An alternative approach would be to use realized values of the endogenous variables as emerge under sticky prices [Woodford 2000].

  6. 6. More specifically, λ t =(−βg1E t Δc t +2+g2EtΔc t +1+g 3 E t Δp t+ 1−g1Δc t −g3R t )/g4, which is equation (42) in Neiss and Nelson [2001]. The g's are defined as follows: g1=(η−σh), g2=(1+βh2−σβh2−σβh), g3=σ(1−βh) and g4=−σ(1−ρ λ +βhρ λ 2−βhρ λ ).

  7. 7. We thank a referee for pointing this out to us.

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Acknowledgements

We thank three anonymous referees for their comments which helped us to improve this paper.

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Authors and Affiliations

  1. Department of Land Economy, Cambridge Centre for Economic and Public Policy, University of Cambridge, 19 Silver Street, Cambridge, CB3 9EP, UK

    Philip Arestis

  2. Department of Economics, University of Athens, Euripidou 14, Athens, Greece

    Georgios E Chortareas

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  1. Philip Arestis
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  2. Georgios E Chortareas
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Arestis, P., Chortareas, G. Atheoretical and Theory-Based Approaches to the Natural Equilibrium Real Interest Rate. Eastern Econ J 34, 390–405 (2008). https://doi.org/10.1057/palgrave.eej.9050040

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