The Mystery of the Falling Natural Real Rate of Interest

A couple of weeks ago Larry Summers held a widely praised speech on the difficulties ahead for economic stabilization policy. As far as I can tell, not much of it was really new, as also pointed out by e.g. Krugman, but that does not mean it wasn’t a great speech, and one that seems to have had considerable influence on the policy debate. In essence it boils down to the problems we face due to the zero lower bound on nominal interest rates, and what happens in a world where the real interest rate required to establish full employment, sometimes also called the natural real interest rate, is negative, as it almost certainly is right now.  Yet from the regression’s I have been running, it would seem that the equilibrium real interest rate was already considerably lower than in previous periods even before the crisis started. In other words, even before the crisis struck, monetary policy already had considerably less room to maneuver than in the decades preceding the the 2000s. To recap, let’s again take a look at a fairly simple Taylor rule one might use to describe Fed policy in the 2000s, more precisely from the first quarter of 2000 to the second quarter of 2009, which is roughly around the time when the zero lower bound started binding.

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