Keywords: Natural rate of interest, interest rate rules, Kalman filter, trend growth, potential output
Abstract: A key variable for the conduct of monetary policy is the natural rate
of interest -- the real interest rate consistent with output equaling
potential and stable inflation. Economic theory implies that the
natural rate of interest varies over time and depends on the trend
growth rate of output. In this paper we apply the Kalman filter to
jointly estimate the natural rate of interest, potential output, and
the trend growth rate, and examine the empirical relationship between
these estimated unobserved series. We find substantial variation in
the natural rate of interest over the past four decades in the United
States. Our natural rate estimates vary about one-for-one with
changes in the trend growth rate. We show that policymakers'
mismeasurement of the natural rate of interest can cause a significant
deterioration in macroeconomic stabilization.
Full paper (204 KB PDF)
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Last update: December 12, 2001