Time Varying Equilibrium Real Rates and Monetary Policy Analysis

FRB of San Francisco Working Paper No. 2004-10

37 Pages Posted: 13 Oct 2004

See all articles by Bharat Trehan

Bharat Trehan

Federal Reserve Bank of San Francisco

Tao Wu

Federal Reserve Bank of San Francisco; Federal Reserve Bank of Dallas

Date Written: June 2004

Abstract

Although it is generally recognized that the equilibrium real interest rate (ERR) varies over time, most recent work on policy analysis has been carried out under the assumption that this rate is constant. We show how this assumption can affect inferences about the conduct of policy in two different areas. First, if the ERR moves in the same direction as the trend growth rate (as is suggested by theory), the probability that an unperceived change in trend growth will lead to a substantial change in inflation is noticeably lower than is suggested by recent analyses (of inflation in the 1970s, for example) that assume a constant ERR. Second, if the monetary authority targets a time varying ERR but the econometrician assumes otherwise, estimated policy rules will tend to exaggerate the degree of interest rate smoothing as well as the weight that the monetary authority places upon inflation.

Keywords: Interest rates, monetary policy

JEL Classification: E52

Suggested Citation

Trehan, Bharat and Wu, Tao and Wu, Tao, Time Varying Equilibrium Real Rates and Monetary Policy Analysis (June 2004). FRB of San Francisco Working Paper No. 2004-10, Available at SSRN: https://ssrn.com/abstract=602764 or http://dx.doi.org/10.2139/ssrn.602764

Bharat Trehan (Contact Author)

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

Tao Wu

Federal Reserve Bank of Dallas ( email )

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

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

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