Natural Rate Of Interest Research Articles

Measuring the Natural Rate of Interest after COVID-19

Measuring the Natural Rate of Interest after COVID-19

Monetary Policy and the Drifting Natural Rate of Interest

Monetary Policy and the Drifting Natural Rate of Interest

Yield curve as forward indicator of recession: Austrian economics insights

This is a heterodox review on macroeconomics according to the Austrian Economics. The Austrian business cycle theory explains the origin of boom-bust cycles based on the difference between natural interest rates and banking rates, which comes from the artificial processes of monetary and credit expansion. This difference is the yield curve, an instrument to detect the deviation of monetary policies, and a forward indicator of business cycles. This article studies the impact of yield curve slope on the requirements for access to bank credit, and the distorting effect of expansionary monetary policies on the capital structure. In an environment of artificially low interest rates, these distortions become an accumulation of long-term failed investments that markets cannot assume, with the consequent readjustment or recession. To detect these distortions and to control the bust, it could be useful the yield curve illustrates here.

Long-run scarring effects of meltdowns in a small-scale nonlinear quadratic model

We build a small-scale nonlinear quadratic (NLQ) model in which credit feedback and regime switches in the output gap affect the adjustment path of the economy towards a steady state. The central bank solves a finite-horizon decision problem where the policy rate also can be zero or negative. We estimate this model by nonlinear seemingly unrelated regression method (NLSUR) and using the parameters to explore policy scenarios. The latter projects long-run dynamics after a large demand contraction leading to scarring effects on the economy. We point out three main results. First, while scars are dominant when the central bank follows a standard Taylor rule, unconventional monetary policy (UMP) – such as Quantitative Easing – mitigates the output decline in both the short and the long run. Second, a zero natural interest rate curtails the central bank’s ability to adjust the economy and mitigate scars. Third, financial constraints leave the deepest scars even if UMP is active.

Global natural projections.

The paper contributes to the debate on natural interest rates and potential growth rates. We build a model-based projection of the world’s most significant economies/areas to improve understanding of their change over the long run and the factors behind their decline. We use a general equilibrium overlapping generation model to understand the simultaneous role of demographics, technology, and globalization. The novelty of the model lies in the way it constructs a human capital index based on UN population projections and an estimated increasing returns production function for major economies worldwide. We find that the decline in interest rates is well explained through labor market dynamics and the increasing obsolescence of capital goods. We also find that a reduced share of labor income has caused movement in the opposite direction, leading to an increase in natural interest rates, which runs counter to the empirical evidence. Moreover, the dynamics of economic integration predict an endogenous adjustment of global imbalances over the long run, with an increasing weight of the Chinese economy and, consequently, a phase of weakness in United States growth between 2030 and 2040. The model is also used to perform shock scenario analysis. We find that demographic decline can adversely affect the growth dynamics for European countries, while a change in the dynamics of globalization can have serious consequences, especially for the United States, with significant benefits for European countries and China.

Demographics, Monetary Policy, and the Zero Lower Bound

AbstractWe develop a New Keynesian life‐cycle model to assess the importance of population aging for monetary policy. The model successfully matches the age profiles of consumption‐savings decisions made by European households. It implies that demographic trends contribute significantly to the decline of the natural rate of interest (NRI) and potential output growth, and exacerbate the risk of hitting the zero lower bound (ZLB), given the current inflation targets. Under a realistic assumption that the central bank updates its estimates of the NRI only with some lag, aging may additionally lead to a sizable and persistent deflationary bias, elevating the ZLB risk even further.

The negative natural rate of interest in the modern theories of Liquidity Trap and Secular Stagnation: back to Böhm-Bawerk via Samuelson

The negative natural rate of interest is since two decades eliciting theoretical and policy debates. It re-emerged, after a relatively long time, in Krugman’s Liquidity Trap model. Later, it was placed at the hearth of the Secular Stagnation theory by Summers. It is argued that Krugman’s negative natural rate of interest ensues from theoretical premises analogous to those present in Samuelson’s overlapping-generations model. In turn, Samuelson obtained a negative equilibrium interest rate by opportunely recasting Böhm-Bawerk’s three causes for a positive rate of interest. The present paper illustrates and analyses this line of thought until its recent developments.

On the international co-movement of natural interest rates

Using quarterly data for 10 OECD countries and the Euro area and a Kalman filtering technique, we investigate the international co-movement among natural interest rates. We show that the US is the main source of global spillovers and global/common factors appear to be key drivers of such co-movement. Indeed, global liquidity is a net transmitter of shocks, while quantitative easing (QE) and the US Dollar are net recipients of shocks. We also find that total spillovers among natural interest rates have been rising since the late nineties, spiking at around economic recessions, periods of US monetary policy tightening, the global financial crisis and the Eurozone sovereign debt crisis. From a policy perspective, our findings suggest: (i) the need of more monetary policy coordination among countries to tackle common drivers of natural rates; (ii) the importance of complementing monetary policy with macro-financial stabilisation tools to ease the global constraints that it faces; (iii) a very gradual and uncertain monetary normalisation path, subject to spikes in financial markets' volatility; and (iv) a (lower) “new normal” level for real policy rates.

Twenty years with the Euro: Eurozone banking market integration revisited

Banking market integration is essential for a stable European Monetary Union but was severely disrupted during the Eurozone crisis. With heterogeneous national banking markets, interpreting the recent post-crisis convergence of national interest rates as restored integration has been challenged in the literature. We therefore scrutinize integration under the condition of market heterogeneity for 12 Eurozone countries before, during and after the Eurozone crisis from 2003 to 2019, employing a novel combination of state-of-the-art network analyses and estimates of bilateral interest rate linkages. We measure integration as bi-directional (Granger) causality relations between lending rates or margins in order to identify crisis-resilient arbitrage mechanisms. Their extent, disruption and restoration inform our subsequent network analysis, which unveils that the Eurozone crisis has fundamentally and persistently disrupted this network beyond the crisis period even when interest rates and margins are converging. Our approach complements and extends existing integration analyses by revealing policy-relevant but otherwise undetected disintegration.

Bubbles and Stagnation

This paper studies the consequences of asset bubbles for economies that are vulnerable to persistent stagnation. Stagnation is the result of a shortage of assets that creates an oversupply of savings and puts downward pressure on the level of interest rates. Once the zero lower bound on the nominal interest rate binds, the real rate cannot fully adjust downward, forcing output to fall instead. In such context, bubbles are useful as they expand the supply of assets, absorb excess savings and raise the natural interest rate - the real rate that is compatible with full employment - crowding in consumption and raising welfare. While safe bubbles are more likely to expand economic activity, riskier bubbles command a risk premium that, in equilibrium, lowers the real interest rate. A lower rate loosens borrowing constraints, potentially improving welfare when financing conditions are especially tight. Finally, fiscal policy that promises a bail-out transfer in case of a bubble collapse can support an existing bubble and improve welfare.

Macroeconomic Drivers and the Pricing of Uncertainty, Inflation, and Bonds

This paper analyzes a new stylized fact: The correlation between uncertainty shocks and changes in inflation expectations has declined and turned negative over the past quarter century. It rationalizes this fact within a standard New Keynesian model with a lower bound on interest rates combined with a decline in the natural rate of interest. With a lower natural rate, the likelihood of the lower bound binding increased and the effects of uncertainty on the economy became more pronounced. In such an environment, increases in uncertainty raise the possibility that the central bank will be unable to eliminate inflation shortfalls following negative demand shocks. As a result, the observed decline in the correlation between uncertainty and inflation expectations emerges. Average-inflation targeting policies can mitigate the longer-run effects of increases in uncertainty on the real economy.

The Natural Rate of Interest Through a Hall of Mirrors

Prevailing explanations of persistently low interest rates appeal to a secular decline in the natural interest rate, or r-star, due to factors outside monetary policy's control. We propose informational feedback via learning as an alternative explanation for persistently low rates, where monetary policy plays a crucial role. We extend the canonical New Keynesian model to an incomplete information setting where the central bank and the private sector learn about r-star and infer each other's information from observed macroeconomic outcomes. An informational feedback loop emerges when each side underestimates the effect of its own action on the other's inference, possibly leading to large and persistent changes in perceived r-star disconnected from fundamentals. Monetary policy, through its influence on the private sector's beliefs, endogenously determines r-star as a result. We simulate a calibrated model and show that this `hall-of-mirrors' effect can explain much of the decline in real interest rates since 2008.

A prolonged period of low interest rates in Europe: Unintended consequences

AbstractWe examine the potential adverse effects of a prolonged period of low interest rates on financial stability from multiple perspectives. First, we provide a unique comparison of natural rates of interest estimated using two approaches—with and without financial factors—for six large European countries inside and outside the euro area. Second, we provide a comprehensive review of the empirical literature, allowing us to identify and categorize financial vulnerabilities, which may be created and fueled by low interest rates. Third, we discuss a situation in which a prolonged period of low interest rates may lead to a point of no return by contributing to higher indebtedness, overvalued asset prices and underpriced risks, resource and credit misallocation, and lower productivity. With respect to all of that, we offer a few monetary policy considerations. Specifically, we suggest that (i) monetary policy should act symmetrically over the medium to long term, (ii) both the short‐term and long‐term costs and benefits of pursuing accommodative or restrictive monetary policy should be accounted for, and (iii) monetary and macroprudential policies need to be coordinated, and their interactions should be accounted for in order to find the best policy mix for the economy.

Rare Disasters, the Natural Interest Rate and Monetary Policy*

AbstractThis article evaluates the impact of rare disasters on the natural interest rate and inflation, and their implications for monetary policy, by using data on natural disasters in OECD countries. Ex‐ante, disaster risk behaves as a negative demand shock and permanently lowers the natural rate and inflation. These effects become larger and nonlinear if the frequency of extreme natural disasters increases. Ex‐post, a disaster realization leads to temporarily higher or lower natural rate and inflation depending on whether supply‐ or demand‐side effects prevail. The article hence shows the importance of disentangling disaster strikes from disaster risk in shaping monetary policy.

Cryptocurrencies, currency competition, and the impossible trinity

We analyze a two-country economy with complete markets, featuring two national currencies as well as a global (crypto)currency. If the global currency is used in both countries, the national nominal interest rates must be equal and the exchange rate between the national currencies is a risk-adjusted martingale. Deviation from interest rate equality implies the risk of approaching the zero lower bound or the abandonment of the national currency. We call this result Crypto-Enforced Monetary Policy Synchronization (CEMPS). If the global currency is backed by interest-bearing assets, additional and tight restrictions on monetary policy arise. Thus, the classic Impossible Trinity becomes even less reconcilable.

Imperfect Competition, Real Estate Prices and New Stylized Facts

In this paper, we develop an overlapping generation model with imperfect competition and land to provide a theoretical foundation for some empirical observations made since the end of the 1970s. The problem is that these new “stylized facts” do not coincide with Kaldor’s stylized facts and unfortunately the standard growth models are not able to explain these new facts. By using our model, we are able to theoretically derive these new facts and to provide a theoretical foundation for them. In particular, increasing market concentration leads to a decline in the labor income share, to a decline in the capital income share, to a decline in the natural interest rate, to an increasing wealth to income ratio, and to an over-proportional increase in land prices in developed countries. The model developed for analysis has close similarity with the standard neoclassical overlapping generation model with endogenous growth and land. The main difference between the standard neoclassical and the model in this paper is the market structure. Instead of assuming perfectly competitive markets, we assume an oligopolistic market structure. This leads to the occurrence of pure profits for firms and, accordingly, the input factors are no longer paid their marginal products.

Secular Drivers of the Natural Rate of Interest in the United States: A Quantitative Evaluation

Secular Drivers of the Natural Rate of Interest in the United States: A Quantitative Evaluation

Asset price bubbles and monetary policy: Revisiting the nexus at the zero lower bound

Asset price bubbles are a major source of macroeconomic instability, but can they play a different role in a low interest rates environment? To answer this question, I study an economy in which the natural rate of interest declines permanently, and the zero lower bound makes risk-free interest rates persistently low. Asset price bubbles redistribute wealth across generations because of the life-cycle pattern of net worth. In this way, they increase the natural interest rate by serving as a store of value for older cohorts and as a collateral for the younger ones, and the central bank can escape from the ZLB with potential output and welfare gains. Output gains are further amplified in presence of capital accumulation and the “financial accelerator”. However, not all bubble types increase the natural interest rate to the same degree and, in this respect, leveraged bubbles have a greater impact than unleveraged bubbles.

Hysteresis and the New Consensus three-equation model: a Post-Keynesian amendment

This paper presents a Post-Keynesian interpretation of the usual three-equation model of New Consensus macroeconomics. The IS curve, Phillips curve, and monetary rule are obtained from stylized facts instead of intertemporal optimization, while price inertia and the government's inflation target drive expected inflation. The result is a model with no unique natural rate of interest. The central bank can still stabilize the economy through trial and error, with demand and supply shocks altering the system's equilibrium and the possibility of secular stagnation.

The Effects of Climate Change on the Natural Rate of Interest: A Critical Survey

The Effects of Climate Change on the Natural Rate of Interest: A Critical Survey