Monetary Policy and the Natural Rate of Interest

16 Pages Posted: 20 Jun 2012

See all articles by Matthew B. Canzoneri

Matthew B. Canzoneri

Georgetown University

Robert E. Cumby

Georgetown University - Department of Economics; National Bureau of Economic Research (NBER)

Behzad Diba

Georgetown University - Department of Economics

Date Written: May 1, 2012

Abstract

Full publication: Threat of Fiscal Dominance?

We identify the economic environments in which it is most important for monetary policy to be able to track the natural rate of interest. To do this, we study two models: one is a standard New Keynesian model; in the other, government spending shocks move the natural rate of interest away from its steady state value and for a protracted period of time. Policy rules that cannot make the policy rate track the natural rate precisely perform poorly in both of these environments. These rules are especially bad in the second model, where the natural rate movements are sustained and the policy rate cannot catch up. In this model, households would give up half a per cent of their consumption each period to have a rule that can track the natural rate. Even in the standard model, households would give up a quarter of a per cent of consumption to obtain such a rule. Consistent with earlier literature, first difference rules perform quite well in this situation, and they do not require any information about the natural rate of interest. In the current climate of big spending cuts, our results suggest central banks would do well to maintain unusually high inertia in their interest rate setting.

Keywords: Monetary policy, natural interest rate, government bonds

JEL Classification: E52, E43

Suggested Citation

Canzoneri, Matthew B. and Cumby, Robert E. and Diba, Behzad, Monetary Policy and the Natural Rate of Interest (May 1, 2012). BIS Paper No. 65g. Available at SSRN: https://ssrn.com/abstract=2078955

Matthew B. Canzoneri (Contact Author)

Georgetown University ( email )

Washington, DC 20057
United States
202-687-5911 (Phone)
202-687-6102 (Fax)

Robert E. Cumby

Georgetown University - Department of Economics ( email )

580 Intercultural Center
Washington, DC 20057
United States
202-687-2990 (Phone)
202-687-6102 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Behzad Diba

Georgetown University - Department of Economics

Washington, DC 20057
United States

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