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Time varying equilibrium real rates and monetary policy analysis

  • Bharat Trehan
  • Tao Wu

Although it is generally recognized that the equilibrium real interest rate (ERR) varies over time, most recent work on policy analysis has been carried out under the assumption that this rate is constant. We show how this assumption can affect inferences about the conduct of policy in two different areas. First, if the ERR moves in the same direction as the trend growth rate (as is suggested by theory), the probability that an unperceived change in trend growth will lead to a substantial change in inflation is noticeably lower than is suggested by recent analyses (of inflation in the 1970s, for example) that assume a constant ERR. Second, if the monetary authority targets a time varying ERR but the econometrician assumes otherwise, estimated policy rules will tend to exaggerate the degree of interest rate smoothing as well as the weight that the monetary authority places upon inflation.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2004-10.

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Date of creation: 2004
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Handle: RePEc:fip:fedfwp:2004-10
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