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The informational content of empirical measures of real interest rate and output gaps for the United Kingdom

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  • Jens D J Larsen
  • Jack McKeown

Abstract

In many economies, the monetary policy instrument is the level of short-term nominal interest rates, but the monetary policy stance might be better characterised by the ex-ante real interest rate that this nominal rate implies, relative to some 'neutral' or 'natural' real rate of interest. In this paper, the natural rate of interest and the real interest rate gap - the difference between the actual and the natural real rate of interest - are estimated by applying Kalman filtering techniques to a small-scale macroeconomic model of the UK economy. In this model, the real interest rate gap, the output gap and inflation are related via IS-curve and Phillips-curve relationships. The natural rate of interest is defined as the level of (ex-ante) real interest rates that is consistent with an output gap of zero, that is output at its natural level, in the medium term. Based on these estimates, the paper examines whether empirical measures of the real interest rate gap are a useful tool for policymakers - do they contain additional information relative to the estimated output gap, and does the real rate gap have leading indicator properties for the output gap and inflation? Are these gap estimates of practical use in a policy setting? The paper finds that the real rate gap has leading indicator properties for both the output gap and inflation. Importantly, these properties have varied considerably over time: breaking the sample into four subsamples, it appears that the leading indicator properties for both the output and real rate gap were substantially stronger for the subsample that covers most of the 1980s. After the introduction of the inflation target, post 1992, the relationship between the real interest rate gap and the output gap strengthens, but the leading indicator properties of these gaps for inflation diminish, as might be expected under an inflation-targeting regime.

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Paper provided by Bank of England in its series Bank of England working papers with number 224.

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Date of creation: Aug 2004
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Handle: RePEc:boe:boeewp:224

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Cited by:
  1. A. Jung, 2013. "Policymakers’ Interest Rate Preferences: Recent Evidence for Three Monetary Policy Committees," International Journal of Central Banking, International Journal of Central Banking, International Journal of Central Banking, vol. 9(3), pages 150-197, September.
  2. Humala, Alberto & Rodríguez, Gabriel, 2009. "Estimation of a Time Varying Natural Interest Rate for Peru," Working Papers, Banco Central de Reserva del Perú 2009-009, Banco Central de Reserva del Perú.
  3. Christian Bustamante & Luis E. Rojas, 2012. "Constant-Interest-Rate Projections and Its Indicator Properties," BORRADORES DE ECONOMIA 009383, BANCO DE LA REPÚBLICA.
  4. Anna Piretti & Charles St-Arnaud, 2006. "Launching the NEUQ: The New European Union Quarterly Model, A Small Model of the Euro Area and U.K. Economies," Working Papers, Bank of Canada 06-22, Bank of Canada.
  5. Ansgar Belke & Jens Klose, 2012. "Modifying Taylor Reaction Functions in Presence of the Zero-Lower-Bound – Evidence for the ECB and the Fed," ROME Working Papers, ROME Network 201203, ROME Network.
  6. Jean-Stéphane MESONNIER, 2007. "The predictive content of the real interest rate gap for macroeconomic variables in the euro area," Money Macro and Finance (MMF) Research Group Conference 2006, Money Macro and Finance Research Group 102, Money Macro and Finance Research Group.
  7. Juan José Echavarría Soto & Enrique López Enciso & Martha Misas Arango & Juana Téllez Corredor- Juan Carlos Parra Álvarez, 2007. "La Tasa De Interés Natural En Colombia," ENSAYOS SOBRE POLÍTICA ECONÓMICA, BANCO DE LA REPÚBLICA - ESPE, BANCO DE LA REPÚBLICA - ESPE.
  8. Garnier, Julien & Wilhelmsen, Bjørn-Roger, 2005. "The natural real interest rate and the output gap in the euro area: a joint estimation," Working Paper Series, European Central Bank 0546, European Central Bank.
  9. Ansgar Belke & Jens Klose, 2010. "(How) Do the ECB and the Fed React to Financial Market Uncertainty? – The Taylor Rule in Times of Crisis," Ruhr Economic Papers, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen 0166, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.
  10. Mésonnier, J-S., 2006. "The Reliability of Macroeconomic Forecasts based on Real Interest Rate Gap Estimates in Real Time: an Assessment for the Euro Area," Working papers, Banque de France 157, Banque de France.
  11. Ronny Mazzocchi, 2013. "Scope and Flaws of the New Neoclassical Synthesis," DEM Discussion Papers, Department of Economics and Management 2013/13, Department of Economics and Management.
  12. Mésonnier, J-S. & Renne, J-P., 2004. "A Time-Varying Natural Rate for the Euro Area," Working papers, Banque de France 115, Banque de France.
  13. Ronny Mazzocchi, 2013. "Monetary Policy when the NAIRI is unknown: The Fed and the Great Deviation," DEM Discussion Papers, Department of Economics and Management 2013/16, Department of Economics and Management.

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