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

Abstract

This paper estimates the natural interest rate 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 novel 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 monetary policy rule in which the domestic real policy rate tracks the Wicksellian domestic short-term natural rate of interest as an additional measure of real economic activity fits the data better than otherwise standard Taylor (1993) rules. Third, we show that over the past thirty-five years, the natural interest rates in all six countries have shifted downwards and strongly co-moved with each other. 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 interest rate in all six small open economies, and that natural rates in these countries co-move strongly with estimated U.S. natural rates.

Keywords: Small Open-Economy Model, Monetary Policy, Natural Rate, Bayesian Estimation

JEL Classification: C11, C13, E43, E58, F41