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Estimating real interest rates for the United Kingdom

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  • Jens Larsen
  • Ben May
  • James Talbot

Abstract

Any monetary policy maker using a short-term nominal interest rate as the primary policy tool will have an interest in understanding developments in ex-ante real interest rates. In this paper, several methods for calculating real interest rates for the United Kingdom are explored. These include: yields on index-linked bonds; yields on nominal bonds minus an appropriate measure of inflation expectations; and a consumption-based measure derived from manipulating the first-order condition of a standard household intertemporal optimisation problem. It is found that the basic (power utility) version of the consumption-based model suffers from the standard problems outlined in the literature, so the basic framework is augmented to allow for (external) habit formation in consumption, and a general k -period real interest rate is derived. Interestingly, although the different approaches outlined above can sometimes yield very different estimates of real interest rates, all the measures move more closely together during the post-1992 inflation-targeting period than before. Before 1992, uncertainty about the monetary regime, coupled with persistent expectational errors, may have made it more difficult for agents to forecast real interest rates and inflation.

Suggested Citation

  • Jens Larsen & Ben May & James Talbot, 2003. "Estimating real interest rates for the United Kingdom," Bank of England working papers 200, Bank of England.
  • Handle: RePEc:boe:boeewp:200
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    File URL: http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/2003/wp200.pdf
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    References listed on IDEAS

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    Cited by:

    1. Baharumshah, Ahmad Zubaidi & Haw, Chan Tze & Fountas, Stilianos, 2005. "A panel study on real interest rate parity in East Asian countries: Pre- and post-liberalization era," Global Finance Journal, Elsevier, vol. 16(1), pages 69-85, August.
    2. Maveyraud-Tricoire, Samuel & Rous, Philippe, 2009. "RIP and the shift toward a monetary union: Looking for a "euro effect" by a structural break analysis with panel data," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 19(2), pages 336-350, April.

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