Blog Post

Blogs review: The natural interest rate framework

What’s at stake: The natural rate of interest is a key ingredient in the recent discussion of secular stagnation, and more generally in New-Keynesian models of the Great Recession. But the concept is often poorly understood, in part because the term refers to different things for different people.

By: Date: January 8, 2014 Topic: Global Economics & Governance

What’s at stake: The natural rate of interest is a key ingredient in the recent discussion of secular stagnation, and more generally in New-Keynesian models of the Great Recession. But the concept is often poorly understood, in part because the term refers to different things for different people.

John Cochrane writes that in most new-Keynesian thinking, our current problem is that the "natural rate" of interest, required to keep us at potential output, is sharply negative. (This is all exogenous.) With "only" 2% inflation and nominal interest rates stuck at zero, the Fed cannot deliver anything less than a negative 2% real rate of interest. If the "natural rate" is something like negative 5%, then we are stuck at a 3% "too high" real interest rate.  

The Wicksellian framework

Richard Anderson writes that the Swedish economist Knut Wicksell based his theory on a comparison of the marginal product of capital with the cost of borrowing money. If the money rate of interest was below the natural rate of return on capital, entrepreneurs would borrow at the money rate to purchase capital (equipment and buildings), thereby increasing demand for all types of resources and their prices; the converse would be true if the money rate was greater than the natural rate of return on capital.

Axel Leijonhufvud writes Wicksell’s terminology divulges his engagement in the ancient quest for a ‘neutral’ monetary system, that is, a system neutral in the original sense that all relative prices develop as they would in a hypothetical world without paper money. Richard Anderson writes that while Wicksell sought to illuminate the transmission mechanism behind the quantity theory and to begin connecting the monetary base, banks’ extension of credit, aggregate demand, and inflation with the natural rate concept, his work laid the foundations that have led economists during the twentieth century to shift away from analysis of the quantity theory.

Greg Ip writes that Wicksell saw financial rates as those set by banks competing to make loans. That job is now performed by central banks. They still think in Wicksellian terms: the natural rate prevails when the economy is at full employment. Set the policy rate above the natural rate and the economy tips into depression. Set it below, and inflation results—or, some worry, speculative credit booms.

The natural interest rate, savings and investment

Axel Leijonhufvud writes that Erik Lindahl (1939) and Gunnar Myrdal (1939) refined the conceptual apparatus, in particular by introducing the distinction between ex ante plans and ex post realizations and thereby clarifying the relationship between Wicksellian theory and national income analysis.

Brad DeLong writes that in the Wicksellian framework, the natural rate of interest is the interest rate at which planned investment (plus net borrowing from the government) is equal to desired saving at full employment (plus the net capital inflow from abroad). If the market rate of interest is below the natural rate, planned investment is greater than desired savings, businesses seeking to invest cannot sell enough bonds to finance investment and thus dip into their cash reserves, the monetary hot potato starts, and you get unexpected and rising inflation (and full or over-full employment).

Source: Brad DeLong

Nick Rowe notes that the Fed can, not only, reduce the market rate, but also try to increase the natural rate. The Fed could also raise the natural rate itself, by doing something (or promising to do something in future) that would increase expected future real income, which would increase current desired investment and reduce current desired saving. Another way of saying the same thing is that it might be useful to distinguish between a short-run and a long-run concept of the natural rate of interest. The short run concept takes the state of expectations as given. The long run concept assumes expectations consistent with the future economy being at the future natural rate. The natural rate of interest is not a number; it’s a time-path.

Alternative definitions of the natural rate of interest

Miles Kimball sees a lot of confusion online about the natural interest rate. The main source of confusion is that there is both a medium-run natural interest rate and a short-run natural interest rate.

  • The medium-run natural interest rate is the interest rate that would prevail at the existing levels of technology and capital if all stickiness of prices and wages were suddenly swept away. That is, the natural rate of interest rate is the interest rate that would prevail in the real-business cycle model that lies behind a sticky-price, sticky-wage, or sticky-price-and-sticky-wage model. The medium-run natural interest rate is not a constant. Indeed, at the introductory macroeconomics level, the standard model of the market for loanable funds is a model of how the medium-run natural interest rate is determined.
  • The short-run natural interest rate is the the rental rate of capital, net of depreciation, in the economy’s actual situation. Low levels of output lowers the net rental rate and therefore lower the short-run natural interest rate. Leaving aside other shocks to the economy, monetary policy will not tend to increase output above its current level unless the interest rate is set below the short-run natural interest rate.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Demographics and Long Run Growth

Scholars have been investigating the relationship between demographics and long term growth, in the context of the secular stagnation hypothesis. We review recent contributions.

By: Silvia Merler Topic: Global Economics & Governance Date: June 18, 2018
Read article More on this topic More by this author

Blog Post

The Italian mini-BOT debate

Talks of parallel currency are not new in Italy. But one of the proposals – the so called mini-BOT – has made it into the government contract that underpins the current League-M5S coalition. We review what has been said about these proposals.

By: Silvia Merler Topic: Finance & Financial Regulation Date: June 11, 2018
Read article More on this topic More by this author

Blog Post

The Italian Crisis

While Italy has been through one of the gravest institutional crises in its history, we review recent opinions on the topic.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: June 4, 2018
Read article More on this topic More by this author

Blog Post

China’s new role in the global economy

The changing role of China in the world economy has recently been highlighted by its registering of a first current account deficit in 17 years. We review the economists’ analyses of this new role and associated challenges.

By: Nicolas Moës Topic: Global Economics & Governance Date: May 28, 2018
Read article More on this topic More by this author

Blog Post

Argentina’s troubles

Argentina has abruptly called on the International Monetary Fund for financial help, amid currency pressures. We review recent economists’ position on this.

By: Silvia Merler Topic: Global Economics & Governance Date: May 22, 2018
Read article More on this topic More by this author

Blog Post

200 Years of Karl Marx

May 5th 2018 marked the 200th anniversary of the birth of Karl Marx. We review some economists’ takes on the controversial philosopher’s legacy.

By: Silvia Merler Topic: Global Economics & Governance Date: May 14, 2018
Read article More on this topic More by this author

Blog Post

Did Economics Fail?

The debate about rethinking economics keeps rambling. We summarise newest contributions to this important discussion.

By: Silvia Merler Topic: Global Economics & Governance Date: May 7, 2018
Read article More on this topic More by this author

Blog Post

The cost of remittances

Remittances flows are very important for developing countries. In 2009 the G8 pledged to reduce the cost of remittances to 5%, a commitment that was endorsed by the G20 in 2011 and 2014, and included in the UN’s Sustainable Development Goals in 2015. What is the cost today, and what are economists’ suggestions to reduce it?

By: Silvia Merler Topic: Global Economics & Governance Date: April 30, 2018
Read article More on this topic More by this author

Blog Post

Trade Wars: what are they good for?

Following the US announcements in early March of their intent to impose steel and aluminum tariffs, and the subsequent threats from China to retaliate with their own tariffs, the global trade picture remains uncertain. The IMF and the World Bank Spring Meetings set off amid US-Japan bilateral negotiations and Trump’s hot-and-cold approach to the TPP. This week we review blogs’ views on tensions over international trade and how they can impact world economic growth.

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: April 23, 2018
Read article More on this topic More by this author

Blog Post

The debate on euro-area reform

A paper jointly written by 14 French and German economists set off a debate about the reform of euro-area macroeconomic governance. We review economists’ opinions about it.

By: Silvia Merler Topic: Finance & Financial Regulation Date: April 16, 2018
Read article More on this topic More by this author

Blog Post

Latvia’s money laundering scandal

Latvia’s third largest bank ABLV sought emergency liquidity from the ECB and eventually voted to start a process of voluntary liquidation, after being accused by US authorities of large-scale money laundering and having failed to produce a survival plan. What does it mean for the ECB?

By: Silvia Merler Topic: Finance & Financial Regulation Date: April 9, 2018
Read article More on this topic More by this author

Blog Post

Milton Friedman's " The role of monetary policy" - 50 years later

In March 1968, Milton Friedman’s “The Role of Monetary Policy” - after his famous presidential address to the American Economic Association - was published in the American Economic Review. 50 years later, economists reflect on this famous work.

By: Silvia Merler Topic: Global Economics & Governance Date: April 3, 2018
Load more posts