Atheoretical and Theory-Based Approaches to the Natural Equilibrium Real Interest Rate

Recent theoretical developments and practical monetary policy concerns have revived interest on the concept of a “natural” equilibrium real interest rate. The natural real interest rate is potentially an important concept for monetary policy makers. The observable market real interest rate and the natural real rate may deviate and the resulting gap can be used to evaluate the stance of monetary policy. A number of diverse empirical approximations to the natural rate exist causing a great deal of uncertainty about its value and concern about its applicability among central bankers. In this paper, we first examine the notion of the natural rate in view of the different interpretations that have been attached to the — unobservable — natural real interest rate and we summarize and critically evaluate the existing approaches for quantifying it. We then use a dynamic stochastic general equilibrium framework to obtain a theory-based measure of the natural interest rate in the US that is time varying. Eastern Economic Journal (2008) 34, 390–405. doi:10.1057/palgrave.eej.9050040