Ties That Bind: Estimating the Natural Rate of Interest for Small Open Economies

This paper estimates the natural rate of interest for six small open economies (Australia, Canada, South Korea, Sweden, Switzerland and the U.K.) with a structural New Keynesian model using Bayesian techniques. Our empirical analysis establishes the following four main findings: First, we show that the open economy framework provides a better fit of the data than its closed economy counterpart for the six countries we investigate. Second, we also show that, in all six countries, a Taylor (1993)-type monetary policy rule that tracks the Wicksellian short-term natural rate fits the data better than a rule that does not. Third, we show that the natural interest rates of all six countries have shifted downwards and strongly comoved with each other over the past 35 years. Fourth, our findings illustrate that foreign output shocks (spillovers from the rest of the world) are a major contributor to the dynamics of the natural rate in these six small open economies and that those natural rates strongly comove also with the existing U.S. natural rate estimates.