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

55 Pages Posted: 8 Apr 2019

See all articles by Valerie Grossman

Valerie Grossman

Federal Reserve Banks - Federal Reserve Bank of Dallas

Enrique Martínez-García

Federal Reserve Bank of Dallas - Research Department

Mark A. Wynne

Federal Reserve Bank of Dallas

Ren Zhang

Texas State University

Multiple version iconThere are 3 versions of this paper

Date Written: March 14, 2019

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

Suggested Citation

Grossman, Valerie and Martinez-Garcia, Enrique and Wynne, Mark A. and Zhang, Ren, Ties that Bind: Estimating the Natural Rate of Interest for Small Open Economies (March 14, 2019). Available at SSRN: https://ssrn.com/abstract=3354898 or http://dx.doi.org/10.2139/ssrn.3354898

Valerie Grossman

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Enrique Martinez-Garcia

Federal Reserve Bank of Dallas - Research Department ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5262 (Phone)

HOME PAGE: http://sites.google.com/view/emgeconomics

Mark A. Wynne

Federal Reserve Bank of Dallas ( email )

PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5159 (Phone)
214-922-5194 (Fax)

Ren Zhang (Contact Author)

Texas State University ( email )

Department of Finance and Economics
McCoy College of Business Administration
San Marcos, TX Texas 78666
United States

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