Personal Website of R.Kannan
Students Corner - Project on Monetary Policy
Assessment of Key Issues

Home Table of Contents Feedback



Visit Title Page
Students Corner

Back to First Page of Module: 6 to view
index of articles

Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 6 Monetary Transmission Mechanism

Real Interest Rates

With interest rates emerging as a key instrument of monetary policy, issues relating to appropriate real rate of interest have attracted debate. Central banks change short-term nominal interest rates to achieve their desired policy objectives. However, what matters for investment and consumption decisions is not the nominal rate but the ex ante real interest rate. Ex ante real interest rate at a given point of time may be defined as nominal rate of interest less expected inflation. There are a number of approaches to measure expected inflation such as periodic surveys or inflation-indexed bonds. However, since reliable data on inflation expectations may not be available in all economies, a common approach is to compute real rates based on actual inflation rates. If the real interest rate, howsoever measured, is lower than the economy's equilibrium real rate, this will stimulate demand in the economy and push output above its potential. Over time, this would put upward pressure on prices. On the other hand, if the actual real rate is above the equilibrium rate, it would lead to deflationary pressures in the economy. Estimates of equilibrium real rate of interest for the economy, therefore, assume importance. A yardstick for such an equilibrium rate is provided by natural (or neutral) rate of interest. As in the case of actual real rate, the natural rate is also unobserved. Accordingly, practical difficulties in its measurement severely limit the use of the natural rate in day-to-day monetary policy formulation (Box VII.3). There are further problems with the measurement of the neutral rate on a real time basis as real time data are subject to sharp revisions. Thus, at best, the neutral rate concept can be useful in historical analysis of monetary policy rather than as a guide for the current and the future conduct of monetary policy. On a real time basis, averages of past real interest rates provide a more accurate estimate of the neutral rate.


Box VII.3
Natural Rate of Interest

Natural rate of interest is defined as the real short-term interest rate consistent with output at its potential and a stable rate of inflation (ECB, 2004). It may also be defined as the equilibrium real rate of return in the case of fully flexible prices. Natural rate is determined by savings and investment in the economy and, therefore, depends upon factors such as time preference of consumers (between current and future consumption), productivity growth, demographics and fiscal policy. If households increase their preference for current consumption vis-à-vis future consumption, this would depress current savings and, thereby raise equilibrium rate of interest. A pick-up in productivity growth and an increase in working-age population will increase investment demand in the economy and this will have the effect of raising the equilibrium rate of interest. Greater uncertainty in the economy - for instance, volatile inflation and exchange rates - will require investors to be compensated for the increased risk premia and this will push up the equilibrium rate. A well-diversified and efficient financial system can enlarge the pool of domestic savings which will reduce the equilibrium rate of interest. In brief, it is apparent that natural rate of interest need not be constant and can increase as well as decrease depending upon movements in the underlying factors. In particular, increase in the trend growth rate of the economy can lead to a commensurate increase in the natural rate of interest.

Difficulties in measuring the fundamental determinants of the natural rate, in turn, make it difficult to identify the appropriate level of natural rate at any point of time. Researchers have accordingly employed a number of statistical techniques such as averaging/filtering of the actual real interest rates as a proxy for the natural rate. These techniques, however, implicitly assume that over long-period of time, on average, the actual real interest rate is close to the natural rate. Another difficulty emanates from the fact that real-time data on key macroeconomic variables necessary for estimating the neutral rate are available with a lot of uncertainty and undergo periodic revisions. This further adds to uncertainty of neutral rate estimates and reduces their utility on a real-time basis (Clark and Kozicki, 2004). In view of these uncertainties, natural rate of interest is not used by central banks in their day-to-day conduct of monetary policy. In brief, natural rate is a useful aid in thinking about monetary policy providing an important benchmark for monetary policy and a potential indicator of monetary policy stance. Its practical relevance is, however, severely limited by the fact of it being unobservable and measurement problems.


Empirical evidence for the US, the UK, France and Germany suggests that the real interest rates increased during 1980s and 1990s over the levels prevailing during the 1950s and 1960s. The low real interest rates during the 1950s and 1960s reflected the greater policy weight assigned to output expansion. Low real interest rates during these periods were also on account of financial repression due to widespread use of statutory pre-emptions. Exchange controls during this period restricted international arbitrage of financial flows and this also enabled low, and even negative, real rates during the 1970s (Kahn and Farrell, 2002). The surge in real rates from 1980s onwards reflected tighter monetary policy to contain inflation. Higher real interest rates since the 1980s also reflected a lax fiscal policy stance and an overall tendency towards deregulation of financial markets.

More recent estimates for the euro area suggest that the natural rate has reversed its rising trend since mid-1990s. The decline in the natural rate in the euro area could be attributed to a number of factors: deceleration in productivity as well as population growth; fiscal consolidation; and, lowering of risk premia. Elimination of exchange rate risk in intra-Euro area following the introduction of euro as well as low and stable inflation contributed to lowering of the risk premia (ECB, 2004). Basdevant et al. (2004) also find evidence that low and stable inflation has led to a reduction in the natural rate in New Zealand since 1992. For the US, estimates suggest that natural rate has shown significant variation over the past four decades and variation in trend growth of output is an important determinant.

A cross-country analysis of interest rates reveals a number of interesting facets. First, real deposit and lending rates have generally moderated since the early 1990s. Second, real interest rates in a number of EMEs are now more stable and generally positive compared to the 1980s. Third, interest rate spreads have also tended to moderate across a number of economies. Fourth, compared to other EMEs, real rates in India are more stable. Both real deposit and lending rates in India are generally higher than those prevailing in the Asian economies but lower than those in Latin American economies. A similar pattern holds for interest rate spreads, although spreads in India are lower than that prevailing in some of the advanced economies.


- - - : ( Monetary Transmission: The Indian Experience ) : - - -
Previous                 Top                   Next

[..Page Last Updated on 15.02.2005..]<>[Chkd-Apvd]