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Estimating a Taylor Rule for New Zealand With a Time-Varying Neutral Real Rate

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IntroductionRecent Developments in Monetary Macroeconomics David Altig The contents of this volume hardly require explanation beyond its title: "Recent Developments in Monetary Macroeconomics." Our intent for the conference was to collect a set of papers reflecting the cutting edge of applied monetary macroeconomics. As befitting such an ambitious-sounding goal, the contributions are wide ranging. For purposes of this brief introduction, however, we might organize the papers as answers to three questions. (1) What is the "optimal" Taylor rule? (2) Are "New Keynesian" or "New Neoclassical Synthesis" models the final word on the monetary transmission mechanism? (3) Is there a role for money in the conduct of monetary policy? What is the "Optimal" Taylor Rule The inclusion of the Taylor rule issue is almost a prerequisite for any collection of papers purporting to survey recent developments in monetary macroeconomics. In policy discussions, the Taylor rule is ubiquitous, and it is currently the choice among alternative specifications of central bank behavior. More precisely, perhaps, the general form of the Taylor rule is the choice, as it has come to represent the general class of equations that relate the federal funds rate to some measure of an output gap and inflation rate. There is substantially less unanimity about whether output gaps and inflation rates should be past, present, or (expected) future values, whether past values of the funds rate need to be included, and what are the appropriate magnitudes of the responses to each of these measures. Marc Giannoni and Michael Woodford offer the natural approach to addressing the dispute: find the representation that is optimal within the framework being employed for policy analysis. The model in question here is essentially a derivative of the "New Neoclassical Synthesis" class of models that are currently the workhorses of most monetary policy analyses among academic and central bank staffs alike. Their approach to discovering the optimal policy within this structure has the flavor of [End Page 1039] the "Ramsey problem" familiar from optimal tax policy, although with the strong requirement that the derived policy rule be "robustly optimal": it must support the optimal equilibrium no matter what the distribution of disturbances the model policymakers face. Giannoni and Woodford offer two essential lessons. First, whether optimal policy incorporates forecasts of future price-level growth or output gaps depend critically on the dynamics of the inflation rate. If the adjustment of the price-level to shocks is inertial, then optimal policy necessarily depends on forecasts of future inflation. Second, the response of the funds rate to its own past is inertial. In fact, it is super-inertial, meaning that (all else equal), the contemporaneous funds rate responds more than one-for-one with the lagged value of the funds rate (and lagged changes in the rate). The proposition that monetary authorities ought to aggressively respond to lagged values of the funds rate also arises in the papers by Jess Benhabib, Stephanie Schmitt-Grohé, and Martín Uribe, and George Evans and Seppo Honkapohja. In the latter case, the authors consolidate and expand on their well-known work on learning dynamics. A central contribution of the work presented in this article is the notion that convergence to a unique rational expectations equilibrium under learning, as well as the stability of that equilibrium, serves as basis for the choice (or rejection) of an optimal policy formulation. An apparent lesson from Evans and Honkapohja's analysis is that the learnability criterion prescribes a policy rule that differs in some important ways from the conventional wisdom coming from analyses that invoke the Taylor rule in a pure rational expectations environment. In particular, they conclude that the optimal policy rule in the environment they consider requires the monetary authority to respond directly to private-sector expectations. The environment they consider is essentially the same as in Giannoni and Woodford, with the exception of the central bank's assumed loss function: Giannoni and Woodford assume a preference for interest rate smoothing, Evans and Honkapohja do not. In his comments, John Duffy points out that the introduction of interest-smoothing motive yields an optimal policy rule under learning that is much closer to the conventional view. In particular, it does not require...

Understanding the behavior of real interest rates is a central issue in monetary/macro economics. Recently researchers have begun to use futures market data to examine real interest rate behavior. Futures market data can be used to directly construct own-commodity real interest rates ? i.e., the ex-ante real return on a bond in terms of specific commodities -- and then the own-commodity real rates can be used to make inferences about the real interest rate for the aggregate economy, This paper examines whether futures market data can be used to understand the behavior of real interest rates. The conclusion is a negative one: Futures market data do not appear to be particularly informative about real interest rates. In coming to this conclusion, the paper examines the data in several ways. First. the ex-ante relative price movement embedded in the own-commodity real rates (the noise) is calculated to be on the order of over one hundred times more variable than the aggregate real interest rate (the signal), Own-commodity real rates are thus unlikely to contain much information about the aggregate real interest rate. Second. several widely accepted facts about the behavior of aggregate real interest rates in the 1960s are not at all evident in the own-commodity real rate data. Thus, analysis of own- commodity real rates provides a misleading impression of aggregate real rate movements for a period which displays the most striking movements of real interest rates in the postwar period. Finally, an econometric analysis of own-commodity real rate behavior fails to find evidence of a shift in the behavior of real interest rates when the monetary policy regime changes in October 1579, a finding that is at odds with previous strong findings in the literature.

This doctoral dissertation is composed of three articles focused on analyzing international spillovers of monetary policy. The first article investigates the spillover effects of monetary policy among OECD countries. First, it appears that, more recently, monetary policy decisions diverge from those indicated by the Taylor Rule. Thus, the article aims to verify if there is a spillover effect in the interest rate decisions of central banks. We apply the methodological framework of spatial econometrics to circumvent the endogeneity problem. Considering the SAR model and a W weight matrix that shows the trade relationship between countries, it is found that countries take into account the international interest rate, besides considering the differential between inflation and its target and the output gap. In the second article, based on classical DSGE models, we analyze the spillover effects of monetary policy by including the foreign interest rate in the domestic monetary agent\\'s decision process. The model shows that the relationship between domestic and foreign interest rates depends on the parameters used, particularly the intertemporal elasticity of consumption and the country\\'s degree of openness. Considering reasonable values for these parameters, we found a positive relationship between the foreign and domestic rates. Furthermore, in the model estimated for Brazil considering the Taylor Rule with Consumer Price Index (CPI), it was found that a negative shock in the US interest rate generates a drop in the Brazilian rate, stimulating activity and consumption. Therefore, domestic prices rise. However, the CPI declines with the appreciation of the exchange rate, leading to a slow return of the interest rate to the steady state. The third paper seeks to measure the welfare costs generated by the spillover effects of monetary policy. Starting from a non-linear model, we apply the methodology proposed by Schmitt-Grohe and Uribe (2004b) and found that regardless of the importance of the foreign interest rate in domestic decisions, the optimal monetary policy is consistent with an aggressive response of interest rates to inflation and a more mild reaction to the output gap. Comparing different rules, we found some evidence that the central bank incurs social welfare loss when considering the international interest rate. Finally, it is worth noting that the cost depends on the Taylor Rule\\'s coefficients and, to a greater extent, on the degree of openness of the economy.

How real interest rates behave over time is critical to our understanding of many macroeconomic issues, and much recent research has pursued this question. Very little of the research, however, has focused on real interest rates outside the United States. This paper is an empirical exploration of real interest rate movements in seven OECD countries from 1967-II to 1979-II. Further research is needed on real rates in other countries for several reasons. Not only are measures of foreign real rates of interest in their ownright, but extending an analysis of real rates to other countries also has the following additional benefits: it can generate more powerful statistical tests of propositions previously tested on U.S. data and yield information on whether results found for the U.S. hold up in other countries.This study pursues several questions that have arisen naturally from this earlier work. Is the hypothesis that the real rate is constant rejected when the analysis is extended to other countries? Does the real rate decline with increased inflation and money growth in other countries besides the United States? How reliable is the Fisher effect, in which nominal interestrates reflect changes in expected inflation? Are movements in nominal interest rates a reliable indicator of movements in real rates? What kind of variationsin real interest rates are there in different countries? Have real rates declined from the '60s to the '70s for other countries besides the U.S.?(This abstract was borrowed from another version of this item.)

An arbitrage-free model decomposes yields on Treasury Inflation-Protected Securities (TIPS) into expected real rates, real frictionless term premiums, and liquidity premiums. Estimation eschews non-market information, incorporates a novel observable liquidity factor, and addresses factor persistence and sample biases, including real-time estimation. Results include a modest secular decline in equilibrium real rates and a much larger drop in frictionless required excess real returns, on net, from July 1999 to September 2022. Real term premiums appear to be pro-cyclical, which implies that the default risk-free asset is a hedge, and some evidence suggests that TIPS liquidity premiums are counter-cyclical.

Is the Euro area as a whole, or are individual Euro-area member countries facing a period of sustained lower economic growth, a phenomenon known as secular stagnation? We tackle this question by estimating equilibrium real interest rates and comparing them to actual real rates. Since the financial crisis has altered the degree of leverage in several European economies, we expand our model to incorporate the financial cycle. We estimate the model for the Euro area as a whole and for nine Euro-area member countries. Incorporating the financial cycle changes the estimated equilibrium real interest rates: For some Euro-area member countries, estimates of the equilibrium real interest rate are substantially higher than the standard estimates. In other cases, including our estimates for the Euro area as a whole, the estimated equilibrium real rates are slightly lower than without taking the financial cycle into account but are still higher than the actual rates. This indicates that real monetary policy rates were set even more systematically and consistently below (or not as far above) the natural real rate. Comparing the sequence of actual and equilibrium real rates, only Belgium, France, and Greece are likely to face a period of secular stagnation.

Previous articleNext article FreeDiscussionPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreThe authors started by thanking both discussants. They agreed with Robert Hall’s assessment that the paper contains two distinct parts but slightly disagreed on their characterization. They viewed the first part as proposing a mechanism for the propagation of a financial crisis and its effect on interest rates. The second part proposes a mechanism for the endogenous persistence of financial crises. The authors clarified that their paper focuses on persistence, whereas both discussants mostly focused on propagation. The authors argued that they opted for a simple yet quantitatively realistic propagation mechanism based on liquidity constraints. Their emphasis is on a novel persistence mechanism and its ability to explain a decrease in riskless interest rates over an extended period of time. Their persistence mechanism relies solely on agents not knowing the true distribution of shocks and estimating it over time.Gregory Mankiw spoke next and asked the authors why they focused specifically on the recent financial crisis instead of taking a more general approach. He suggested that they could study other related episodes, including the Great Depression and the Great Moderation. Several participants proposed alternative approaches to validate the authors’ mechanism. Gita Gopinath suggested looking at disasters in emerging markets. Valerie Ramey recommended investigating the response of land prices to earthquakes. Emmanuel Farhi proposed studying a broader class of assets and analyzing whether their behavior is consistent with the prediction of the authors’ theory. He suggested looking into the cross-section of stocks and exchange rates during and following the Great Recession. The authors were sympathetic to these suggestions. They explained that they could not extend their analysis to the Great Depression due to data limitations.Mankiw pointed out that real rates have decreased over time since the Great Depression, whereas the authors’ persistence mechanism would predict a recovery following the initial decrease. The authors confirmed that their mechanism would indeed predict such a recovery but noted that real rates are affected by other factors outside the scope of their analysis. Robert Gordon followed up on the issue and questioned the existence of a secular decline in real interest rates. He argued that inspecting the series for real rates from the 1980s onward is misleading, referring to a plot displayed by Hall during his discussion. Gordon noted that the 1980s were times of tight monetary policy and easy fiscal policy, which led to high real interest rates. He added that real interest rates were actually low in the 1960s due to surprise inflation during the Vietnam War and in the 1970s due to an oil supply shock. Gordon suggested that notion of a secular decline in real interest rates may become obsolete over the next 5 years.Andrea Eisfeldt followed up on the question of rare disasters and referred to the work of Tyler Muir (“Financial Crises and Risk Premia,” Quarterly Journal of Economics 132, no. 2 [2017]: 765–809). Using a large cross-section of countries and a long time series, Muir documents that bond spreads respond to bank net worth shocks but not to wars or other events affecting consumption growth or the capital stock. Eisfeldt noted that this finding suggests that the response of bond spreads to leverage shocks may be muted. On the other hand, she raised the possibility that shocks to the collateral value of banks could have a sizable effect. The authors were very receptive to Eisfeldt’s suggestion. They added that the response of spreads to an increase in perceived tail risk is quite modest in their model. The reason for this small response is that firms deleverage when credit risk increases. Eisfeldt noted that a friction to deleveraging would be required to obtain a larger effect.The rest of the discussion focused on the nature of belief formation in the authors’ model. Michael Woodford was very sympathetic to the idea that observing unusual events affects agents’ beliefs about the probability of tail risk. He viewed the authors’ evidence on options prices as compelling in this respect. Woodford was more skeptical, though, that the authors’ simple model of learning could capture important features of the belief formation process. He emphasized that the size of the data set that agents use to form their expectations plays a critical role. Woodford noted that if this data set expands over time, agents will infer the true distribution of shocks asymptotically, so surprises about this distribution eventually disappear. He concluded that the window must be of finite length for the authors’ mechanisms to be present in the long run. In Woodford’s opinion, a window of fixed length wouldn’t be particularly relevant either. As an example, he noted that prior to the Great Recession many economists assumed data prior to World War II was no longer relevant for assessing risks for the US economy, invoking policy and institutional changes. After the Great Recession, however, there was a renewed interest in the profession in the Great Depression and its policy lessons. Woodford argued that it is important to endogenize the window used for belief formation.Pierre-Olivier Weill seconded Woodford’s point and suggested that the natural next step would be a model of attention choice, where agents choose which episodes to consider when forming their beliefs. Wendy Edelberg noted that agents’ beliefs may overshoot in response to a tail event. This response is not captured in the authors’ model. She raised the possibility that this mechanism could decrease the degree of persistence in their model, as agents realize that their beliefs are incorrect. Martin Eichenbaum added that there is strong evidence of generational effects: old households put a lower weight on new observations when forming beliefs, relative to young households. Eichenbaum provided two examples: heterogeneity in inflation expectations by age and in risk taking in the financial industry between those who experienced the 2007–8 crisis and those who did not.In response to Woodford, the authors said they saw a virtue in considering a modest deviation from rational expectation and showing that it yields a substantially different response to rare events. They added that they also performed an exercise in which they discounted the weights on observations by 1% a year, which may capture the generational effect mentioned by Eichenbaum.Eichenbaum concluded the general discussion by inviting researchers to be less apologetic about deviating from rational expectations. Previous articleNext article DetailsFiguresReferencesCited by NBER Macroeconomics Annual Volume 332018 Sponsored by the National Bureau of Economic Research (NBER) Article DOIhttps://doi.org/10.1086/700913 © 2019 by the National Bureau of Economic Research. 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This paper estimates neutral real interest rate (NRIR) ranges for 10 Latin American countries that either have full-fledged inflation targeting regimes in place or have recently adopted them, using an array of methodologies commonly used in the literature. We find that NRIRs have declined in the last decade, with more economically and financially developed economies exhibiting lower NRIR levels. Based on the estimated NRIRs, we assess that the current monetary stance (measured by the interest rate gap) is appropriately neutral in most of the considered economies, in line with closing output gaps. We also observe that the interest rate gap can be a good predictor of future inflation dynamics and economic growth. In addition, looking at the recent experiences in Brazil and Peru, we suggest that macro-prudential policies could affect the monetary stance even in the absence of direct interest rate changes, through affecting the NRIR.

Monetary Policy Inertia and the Paradox of Flexibility

This paper presents a framework for analyzing how bounded rationality affects monetary and fiscal policy. The model is a tractable and parsimonious enrichment of the widely-used New Keynesian model - with one main new parameter, which quantifies how poorly agents understand future policy and its impact. That myopia parameter, in turn, affects the power of monetary and fiscal policy in a microfounded general equilibrium. A number of consequences emerge. (i) Fiscal stimulus or helicopter drops of money are powerful and, indeed, pull the economy out of the zero lower bound. More generally, the model allows for the joint analysis of optimal monetary and fiscal policy. (ii) The Taylor principle is strongly modified: even with passive monetary policy, equilibrium is determinate, whereas the traditional rational model yields multiple equilibria, which reduce its predictive power, and generates indeterminate economies at the zero lower bound (ZLB). (iii) The ZLB is much less costly than in the traditional model. (iv) The model helps solve the forward guidance puzzle : the fact that in the rational model, shocks to very distant rates have a very powerful impact on today's consumption and inflation: because agents are partially myopic, this effect is muted. (v) Optimal policy changes qualitatively: the optimal commitment policy with rational agents demands nominal GDP targeting ; this is not the case with behavioral firms, as the benefits of commitment are less strong with myopic firms. (vi) The model is neo-Fisherian in the long run, but Keynesian in the short run: a permanent rise in the interest rate decreases inflation in the short run but increases it in the long run. The non-standard behavioral features of the model seem warranted by the extant empirical evidence.

This paper shows that the divine‐coincidence does not hold in a sticky price model with external habit if a time‐varying tax rate on labor income is not implemented to fully eliminate the time‐varying distortions associated with external habit and monopoly power in goods market. The required labor income tax rate is inversely related to the risk‐free real interest rate and the markup in the goods market, but it is proportional to the degree of external habit. Under this circumstance, the optimal monetary policy commands a countercyclical interest rate, having a perfect negative correlation with tax rate in the sticky price model with external habit. If a time‐invariant tax is the only fiscal instrument, then the degree of external habit entails a gap between the private marginal rate of substitution between consumption and labor and the social marginal rate of substitution, generating an endogenous trade‐off between the stabilization of welfare‐relevant output gap and inflation. Under this circumstance, price stability is not the optimal policy. The monetary policy authority should optimally try to undo the time‐varying distortions associated with external habit and monopoly power in goods market by deviating from price stability.

This paper estimates neutral real interest rate (NRIR) ranges for 10 Latin American countries that either have full-fledged inflation targeting regimes in place or have recently adopted them, using an array of methodologies commonly used in the literature. We find that NRIRs have declined in the last decade, with more economically and financially developed economies exhibiting lower NRIR levels. Based on the estimated NRIRs, we assess that the current monetary stance (measured by the interest rate gap) is appropriately neutral in most of the considered economies, in line with closing output gaps. We also observe that the interest rate gap can be a good predictor of future inflation dynamics and economic growth. In addition, looking at the recent experiences in Brazil and Peru, we suggest that macro-prudential policies could affect the monetary stance even in the absence of direct interest rate changes, through affecting the NRIR.

Optimal monetary policy in a small open economy with inflation and output persistence