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Monetary policy and the drifting natural rate of interest

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  • Sandra Daudignon
  • Oreste Tristani

Abstract

Empirical analyses starting from Laubach and Williams (2003) find that the natural rate of interest is not constant in the long-run. This paper studies the optimal response to stochastic changes of the long-run natural rate in a suitably modified version of the new Keynesian model. We show that, because of the zero lower bound (ZLB) on nominal interest rates, movements towards zero of the long-run natural rate cause an increasingly large downward bias in expectations. To offset this bias, the central bank should aim to keep the real interest rate systematically below the long-run natural rate, as long as policy is not constrained by the ZLB. The neutral rate – the level of the policy rate consistent with stable inflation and the natural rate at its long-run level – will be lower than the long-run natural rate. This is the case both under optimal policy, and under a price level targeting rule. In the latter case, the neutral rate is equal to zero as soon as the long-run natural rate falls below 1%.

Suggested Citation

  • Sandra Daudignon & Oreste Tristani, 2022. "Monetary policy and the drifting natural rate of interest," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 22/1057, Ghent University, Faculty of Economics and Business Administration.
    • Handle: RePEc:rug:rugwps:22/1057
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    More about this item

    Keywords

    nonlinear optimal policy; zero lower bound; commitment; liquidity trap; New Keynesian; natural rate of interest;
    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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