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Looking for the stars: Estimating the natural rate of interest

Mengheng Li () and Irma Hindrayanto ()
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Irma Hindrayanto: Economic Research and Policy Division, De Nederlandsche Bank, The Netherlands

No 51, Working Paper Series from Economics Discipline Group, UTS Business School, University of Technology, Sydney

Abstract: Natural rate of interest or r-star and the natural rate of output growth are important policy benchmarks widely used by central banks to determine the stance of an economy. It is well recognized that r-star, linearly related to the natural rate of output growth within the New Keynesian framework, is subject to low-frequency fl uctuations. To track its evolution over time, we propose an unobserved components model with similar cycles based on the work of Holston et al. (2017). Our model takes an estimate of the time-varying natural rate of output growth as input via a first-stage model based on a first-difference version of Okun's law with time-varying parameters. In the second-stage, the full model is estimated using Kalman filter. We also show that the similar cycles imply a Taylor rule and a hybrid New Keynesian Phillips curve. For US, EA and UK, our estimates suggest that the decline of natural rate of output growth started from the 1960s, while r-star for US and EA started to fall from 1985. R-star of UK started low during 1960s, but rose and stayed relatively high in the 80s until a big drop took place during the GFC.

Keywords: Natural rate of interest; Potential growth rate; Trend growth; Secular stagnation; Phillips curve; Monetary policy rules; Unobserved components models; Similar cycles; Kalman filter (search for similar items in EconPapers)
JEL-codes: C32 E43 E52 O40 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba and nep-mac
Date: 2018-10-30
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