Monetary Policy and the Natural Rate of Interest

Full publication: "http://ssrn.com/abstract=2078895" Threat of Fiscal Dominance?We identify the economic environments in which it is most important for monetary policy to be able to track the natural rate of interest. To do this, we study two models: one is a standard New Keynesian model; in the other, government spending shocks move the natural rate of interest away from its steady state value and for a protracted period of time. Policy rules that cannot make the policy rate track the natural rate precisely perform poorly in both of these environments. These rules are especially bad in the second model, where the natural rate movements are sustained and the policy rate cannot catch up. In this model, households would give up half a per cent of their consumption each period to have a rule that can track the natural rate. Even in the standard model, households would give up a quarter of a per cent of consumption to obtain such a rule. Consistent with earlier literature, first difference rules perform quite well in this situation, and they do not require any information about the natural rate of interest. In the current climate of big spending cuts, our results suggest central banks would do well to maintain unusually high inertia in their interest rate setting