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Looking for the stars: Estimating the natural rate of interest

Author

Listed:
  • Mengheng Li

    (Economics Discipline Group, University of Technology Sydney)

  • Irma Hindrayanto

    (Economic Research and Policy Division, De Nederlandsche Bank, The Netherlands)

Abstract

Natural rate of interest or r-star and the natural rate of output growth are important policy benchmarks widely used by central banks to determine the stance of an economy. It is well recognized that r-star, linearly related to the natural rate of output growth within the New Keynesian framework, is subject to low-frequency fluctuations. To track its evolution over time, we propose an unobserved components model with similar cycles based on the work of Holston et al. (2017). Our model takes an estimate of the time-varying natural rate of output growth as input via a first-stage model based on a first-difference version of Okun's law with time-varying parameters. In the second-stage, the full model is estimated using Kalman filter. We also show that the similar cycles imply a Taylor rule and a hybrid New Keynesian Phillips curve. For US, EA and UK, our estimates suggest that the decline of natural rate of output growth started from the 1960s, while r-star for US and EA started to fall from 1985. R-star of UK started low during 1960s, but rose and stayed relatively high in the 80s until a big drop took place during the GFC.

Suggested Citation

  • Mengheng Li & Irma Hindrayanto, 2018. "Looking for the stars: Estimating the natural rate of interest," Working Paper Series 51, Economics Discipline Group, UTS Business School, University of Technology, Sydney.
    • Handle: RePEc:uts:ecowps:51
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    References listed on IDEAS

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    More about this item

    Keywords

    Natural rate of interest; Potential growth rate; Trend growth; Secular stagnation; Phillips curve; Monetary policy rules; Unobserved components models; Similar cycles; Kalman filter;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • O40 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - General

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