Natural Rate of Interest

What is the Natural Rate of Interest?

The natural rate of interest is referred to by a number of names. This includes the neutral interest rate, neutral rate, r* (r-star), and the long-run equilibrium interest rate. This interest rateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicle or building, or just consumer goods. is the theoretical short-term interest rate that would support the economy at maximum output or full employment GDPGross Domestic Product (GDP)Gross domestic product (GDP) is a standard measure of a country’s economic health and an indicator of its standard of living. Also, GDP can help compare the while keeping inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The cause for inflation in the short and me constant. This rate is often referred to by central banks when making decisions about the bank rate since this neutral rate is essentially the division between expansionaryExpansionary Monetary PolicyAn expansionary monetary policy is a type of macroeconomic monetary policy that aims to increase the rate of monetary expansion to stimulate the growth of and contractionaryContractionary Monetary PolicyA contractionary monetary policy is a type of monetary policy that is intended to reduce the rate of monetary expansion to fight inflation. The rise in monetary policy. Although the usage of this concept dates back to 1898 by Swedish economist Knut Wicksell, it wasn’t until the 1990s that this concept became more used due to central banks increasing the level of scrutiny around targetting interest rates.

Why is the Natural Rate of Interest Important?

The natural rate of interest is very important in the role that it plays in monetary policyMonetary PolicyA monetary policy is an economic policy that manages the size and growth rate of the money supply in the economy. It is a powerful tool to regulate the. Depending on what the central bank believes is neutral, they will implement the short-term bank rate accordingly. In times where they believe the economy needs a stimulusExpansionary Monetary PolicyAn expansionary monetary policy is a type of macroeconomic monetary policy that aims to increase the rate of monetary expansion to stimulate the growth of, they will set the bank rate below the neutral rate. If the central bank believes the economy needs a cooling-offContractionary Monetary PolicyA contractionary monetary policy is a type of monetary policy that is intended to reduce the rate of monetary expansion to fight inflation. The rise in period, they will set the bank rate above the neutral rate.

A monetary policy such as the central bank’s decision to increase or decrease short term interest ratesInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicle or building, or just consumer goods. can have huge effects on the economy. This decision will affect inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The cause for inflation in the short and me, unemployment, exchange ratesForeign ExchangeForeign exchange (FOREX or FX) is the conversion of one currency into another at a specific rate known as the foreign exchange rate. The conversion rates and the GDPGross Domestic Product (GDP)Gross domestic product (GDP) is a standard measure of a country’s economic health and an indicator of its standard of living. Also, GDP can help compare the growth of a country. Due to the importance of setting interest rates, understanding where the neutral rate lies is vital to making effective policy decisions. These decisions are so impactful that a central bank weighing in on their opinion of where the current bank rate lies in relation to the neutral rate is an indicator they may consider changing the bank rate. Just knowing the central bank’s stance on the neutral rate can lead to market ralliesRallyA rally refers to a period of continuous increase in the prices of stocks, indexes or bonds. The word rally is typically used as a buzzword by business media outlets such as Bloomberg to describe a period of increasing prices. or sell-offs.

Natural Rate of Interest vs Market Rate of Interest

In Wicksell’s theory about the natural rate of interest, the most important thing to consider was the difference between this rate and the market rate of interest. Based on whether the market interest rate is above or below the natural interest rate, conclusions can be drawn.

The market interest rate is the actual interest rateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicle or building, or just consumer goods. that is paid on deposits and investments. This is determined by the supply and demand for funds in the money marketMoney MarketThe money market is an organized exchange market where participants can lend and borrow short-term, high-quality debt securities with average maturities of one year or less. and is dependant on the rate the central bank sets.

According to Wicksell, in the short term, the market interest rate and natural rate are often different. When the market interest rate is below the natural rate, the supply of savings is less than the demand for loans. In this scenario, the total demand for money is higher than the supply and assuming this demand is financed by expansion in bank loans, this leads to increasing prices.

In the opposite scenario, the market interest rate can be above the neutral interest rate. Here, the supply of savings is more than the demand for loans. Bank loans will contract which will lead to falling prices. According to Wicksell, this is why when the market interest rate is equal to the natural interest rate, inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The cause for inflation in the short and me is stable.

How is the Natural Rate of Interest Determined?

Although this concept is very important, the natural rate of interest is not a number that can be determined with a high level of certainty. This unobservable rate must be inferred based on a number of factors. There will generally be significant disagreement between the different estimates and models used to come to these conclusions. The most common model used to determine the natural interest rateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicle or building, or just consumer goods. is the Laubach-Williams model.

The Laubach-Williams approach was developed by Federal Reserve economists Thomas Laubach and John Williams. They published this paper in 2003. This model assumes a relationship between interest rates and economic activity. It takes a KeynesianKeynesian Economic TheoryKeynesian Economic Theory is an economic school of though which broadly states that government intervention is needed to help economies emerge out of recess approach where an increase in the real rate should, in theory, lead to a reduction in consumption and investment. The natural rate in this model is calculated by using a Kalman filter and uses data such as GDP growth, inflation, and the central bank rate.

Additional Resources

Thank you for reading CFI’s article on the natural rate of interest. If you would like to learn about related concepts check out CFI’s other resources:

• Interest RateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicle or building, or just consumer goods.
• Keynesian EconomicsKeynesian Economic TheoryKeynesian Economic Theory is an economic school of though which broadly states that government intervention is needed to help economies emerge out of recess
• Monetary PolicyMonetary PolicyA monetary policy is an economic policy that manages the size and growth rate of the money supply in the economy. It is a powerful tool to regulate the
• InflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The cause for inflation in the short and me