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Understanding the natural rate of interest for a small open economy

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  • Zarazúa Juárez, Carlos Alberto

Abstract

In this paper, we develop a structural model to estimate the current level of the natural rate for a small open economy, featuring a rich set of shocks to provide economic intuition for its underlying drivers. The model follows the New Keynesian tradition with several frictions and is able to draw implications for a monetary policy stance. In contrast to other DSGE models in the literature, this framework includes two main blocks—one related to the foreign sector and one associated with the local economy, linked by the uncovered interest rate parity condition. With this structure, the natural rate is affected by local and external factors, disaggregated in permanent and transitory shocks. Using Bayesian techniques, the model estimates the natural interest rate for two example cases, Mexico and Canada, considering data from these economies and the United States. Results show that the US economy is relevant to explaining natural rates in both countries. For the Mexican case, the drivers are shocks to the US risk premium and the marginal efficiency of investment, as well as country risk premium variations. For Canada, shocks to the households’ discount factor play an important role.

Suggested Citation

  • Zarazúa Juárez, Carlos Alberto, 2023. "Understanding the natural rate of interest for a small open economy," Latin American Journal of Central Banking (previously Monetaria), Elsevier, vol. 4(3).
    • Handle: RePEc:eee:lajcba:v:4:y:2023:i:3:s2666143823000145
    DOI: 10.1016/j.latcb.2023.100093
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    More about this item

    Keywords

    Monetary policy; Central banking; Interest rates;
    All these keywords.

    JEL classification:

    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • E49 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Other
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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