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Monetary policy and the drifting natural rate of interest

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  • Daudignon, Sandra
  • Tristani, Oreste

Abstract

Empirical analyses find that the long-run natural rate, or the real rate prevailing over a long-run equilibrium where nominal rigidities are absent, is subject to permanent shocks. How should monetary policy react to such shocks? Our paper answers this question in a variant of the new Keynesian model. Because of the zero lower bound (ZLB) on nominal interest rates, the mere possibility of future movements towards zero of the long-run natural rate imparts a downward bias on inflation expectations. To offset this bias, a central bank optimizing under commitment should not only rely on forward guidance at the ZLB, as recommended by the existing literature, but also adopt an expansionary bias away from the ZLB. The neutral rate, i.e. the real policy rate consistent with stable inflation in the long-run, should fall more than one-to-one with the long-run natural rate, as the latter approaches zero. This is the case both under optimal commitment policy, and if optimal policy is implemented through a price level targeting rule. JEL Classification: C63, E31, E52

Suggested Citation

  • Daudignon, Sandra & Tristani, Oreste, 2023. "Monetary policy and the drifting natural rate of interest," Working Paper Series 2788, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20232788
    Note: 24907
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    Cited by:

    1. Rodolfo G. Campos & Jesús Fernández-Villaverde & Galo Nuño & Peter Paz, 2024. "Navigating by Falling Stars: Monetary Policy with Fiscally Driven Natural Rates," NBER Working Papers 32219, National Bureau of Economic Research, Inc.
    2. Rodolfo G. Campos & Jesús Fernández-Villaverde & Galo Nuño & Peter Paz, 2024. "Navigating by Falling Stars: Monetary Policy with Fiscally Driven Natural Rates," NBER Working Papers 32219, National Bureau of Economic Research, Inc.

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    More about this item

    Keywords

    liquidity trap; new Keynesian model; optimal monetary policy with commitment; zero lower bound;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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