The equilibrium real policy rate through the lens of standard growth models

Daniel Sichel () and J. Christina Wang

No 17-6, Current Policy Perspectives from Federal Reserve Bank of Boston

Abstract: The long-run equilibrium real policy rate is a key concept in monetary economics and an important input into monetary policy decision-making. It has gained particular prominence lately as the Federal Reserve continues to normalize monetary policy. In this study, we assess the evolution, current level, and prospective values of this equilibrium rate within the framework of standard growth models. Our analysis considers as a baseline the single-sector Solow model, but it places more emphasis on the multi-sector neoclassical growth model, which better fits the data over the past three decades. We find that the long-run equilibrium policy rate has fallen between 0.3 and more than 1.6 percentage points from the 1973?2007 historical average, depending on the model and parameter values, mainly because of slower growth in total factor productivity (TFP) and the labor force. To the extent that the recent sluggish TFP growth persists, our estimates suggest a range of 0 percent to 1 percent for the equilibrium real rate in the current policy setting. But these estimates are subject to a substantial degree of uncertainty, as has been found in other studies. Policymakers thus need to interpret cautiously the guidance from policy rules that depend on the long-run equilibrium rate. This uncertainty also highlights the importance of the Federal Reserve?s standard practice of constantly monitoring a wide range of indicators of inflation and real activity to gauge as accurately as possible the economy?s reaction to policy.

Keywords: monetary policy; productivity; natural rate of interest; growth models (search for similar items in EconPapers)
JEL-codes: E43 E52 O33 O41 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2017-11-17
New Economics Papers: this item is included in nep-mac and nep-mon
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