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Credit and the Natural Rate of Interest

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  • FIORELLA DE FIORE
  • ORESTE TRISTANI

Abstract

We analyze the properties of the natural rate of interest in an economy with asymmetric information between borrowers and lenders, and nominal debt contracts. In our model, monetary policy has real effects in the flexible‐price equilibrium because it affects the cost of external finance. As a consequence, under the standard definition, the natural rate of interest is not a useful policy indicator because it is itself affected by monetary policy. We propose a generalized definition and demonstrate that the resulting natural rate (i) is not policy dependent and (ii) delivers price stability if used as the intercept of a monetary policy rule. From a qualitative perspective, the dynamics of the natural rate in response to shocks can be very different in economies with or without financial frictions. Quantitatively, the policy implications of these differences tend to be minor for real shocks, but sizable for financial shocks of the magnitude observed during the financial crisis of 2007–09.
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Suggested Citation

  • Fiorella De Fiore & Oreste Tristani, 2011. "Credit and the Natural Rate of Interest," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43, pages 407-440, March.
    • Handle: RePEc:mcb:jmoncb:v:43:y:2011:i::p:407-440
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    More about this item

    JEL classification:

    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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