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Money and the natural rate of interest: structural estimates for the United States and the Euro area

  • Javier Andrés
  • J. David López-Salido
  • Edward Nelson

We examine the role of money, allowing for three competing environments: the New Keynesian model with separable utility and static money demand; a non-separable utility variant with habit formation; and a version with adjustment costs for holding real balances. The last two variants imply forward-looking behavior of real money balances, as it is optimal for agents to allow their forecast of future interest rates to affect current portfolio decisions. We distinguish between these specifications by conducting a structural econometric analysis for the U.S. and the euro area. FIML estimates confirm the forward-looking character of money demand. Using these estimates we find that, in response to preference and technology shocks, real money balances are valuable in anticipating future variations in the natural interest rate.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2007-005.

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Date of creation: 2007
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Handle: RePEc:fip:fedlwp:2007-005
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