On Measuring the Natural Rate of Interest

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Daniel Buncic

Stockholm University - Stockholm Business School

Date Written: November 4, 2020

Abstract

Holston, Laubach and Williams’ (2017) estimates of the natural rate of interest are based on a misspecified Stage 2 model. This paper corrects the misspecification in their Stage 2 model and provides updated estimates of the natural rate of interest from their model. This correction is quantitatively important. It yields a substantially smaller point estimate of the signal-to-noise ratio parameter λ(z) which determines the size of the downward trend of ‘other factor’ z(t) in the natural rate. For US data, the point estimate of λ(z) shrinks from 0.040 to 0.013 and is statistically highly insignificant. For data on the Euro Area, the UK and Canada, the λ(z) point estimates are zero. These results highlight that the effect of ‘other factor’ z(t) on the natural rate is substantially subdued once Holston et al.’s (2017) estimation procedure is implemented on a correctly specified Stage 2 model, leading to considerably larger estimates of the natural rate of interest from their model.

Keywords: Natural rate of interest, Median Unbiased Estimation, Kalman Filter, misspecified econometric models, correction to Stage 2 model.

JEL Classification: C32, E43, E52, O40

Suggested Citation

Buncic, Daniel, On Measuring the Natural Rate of Interest (November 4, 2020). Available at SSRN: https://ssrn.com/abstract=

Daniel Buncic (Contact Author)

Stockholm University - Stockholm Business School

Sweden

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