Money As Indicator for the Natural Rate of Interest

IMF Working Papers, January 1, 2012

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The natural interest rate is of great relevance to central banks but is difficult to measure.
In a standard microfounded monetary model, the natural interest rate co-moves with a transformation of the money demand that can be computed from actual data.
The co-movement between the transformed money demand and the natural interest rate is of a considerable magnitude and independent of monetary policy.
Combining the transformed money demand and the observed output gap provides the best information about the natural interest rate.

The analysis uses a standard microfounded monetary model to link the natural interest rate and money demand.
The transformed money demand is computable from actual data and serves as an indicator for the natural interest rate.
The documented co-movement is robust to different monetary policy regimes (described as independent of monetary policy).

An optimizing central bank that does not observe the natural interest rate can incorporate the transformed money demand into its policy rule.
A simple but optimal interest rate rule should include:
- the transformed money demand,
- the observed output gap,
- inflation.
Including both the transformed money demand and the observed output gap yields the best information set about the natural interest rate for policy design.

Subject: Banking, Consumption, Demand for money, Monetary policy, Monetary policy frameworks, Money, National accounts, Output gap, Production, Productivity
Keywords: Consumption, Demand for money, gap coefficient, interest rate rule, monetary policy, Monetary policy frameworks, money demand, money gap, Natural interest rate, observed output gap, optimal monetary rule, Output gap, policy rule, Productivity, WP