IMF paper measures the natural rate of interest

An International Monetary Fund paper published on January 11 says central banks that cannot observe the natural rate of interest can instead use money demand, the observed output gap and inflation as a proxy measure.

The paper's authors, Helge Berger and Henning Weber, employ a conventional microfounded monetary model to measure the natural interest rate. While this rate is an important benchmark of the monetary policy stance, they say it is difficult to measure.

The authors show the natural interest rate co-moves with a transformation of the money demand. The co-movement is of a considerable magnitude and independent of monetary policy. They argue that an optimising central bank that does not observe the natural interest rate can take advantage of this co-movement by incorporating the transformed money demand, in addition to the observed output gap and inflation, into a simple but optimal interest rate rule. Combining the transformed money demand and the observed output gap provides the best information about the natural interest rate.

Click here to read the paper.