Template-Type: ReDIF-Paper 1.0
Author-Name: Phurichai Rungcharoenkitkul
Author-X-Name-First: Phurichai
Author-X-Name-Last: Rungcharoenkitkul
Author-Name: Fabian Winkler
Author-X-Name-First: Fabian
Author-X-Name-Last: Winkler
Title: The natural rate of interest through a hall of mirrors
Abstract: Prevailing justifications of low-for-long interest rates appeal to a secular decline in the natural interest rate, or r-star, due to factors outside monetary policy's control. We propose informational feedback via learning as an alternative explanation for persistently low rates, where monetary policy plays a crucial role. We extend the canonical New Keynesian model to an incomplete information setting where the central bank and the private sector must learn about r-star and infer each other's information from observed macroeconomic outcomes. An informational feedback loop emerges when each side underestimates the effect of its own action on the other's inference, leading to large and persistent changes in perceived r-star disconnected from fundamentals. Monetary policy, through its influence on the private sector's beliefs, endogenously determines r-star as a result. We simulate a calibrated model and show that this 'hall of mirrors' effect can explain much of the decline in real interest rates since 2008.
Length: 49 pages
Creation-Date: 2021-11
File-URL: https://www.bis.org/publ/work974.pdf
File-Format: Application/pdf
File-Function: Full PDF document
File-URL: https://www.bis.org/publ/work974.htm
File-Format: text/html
Number: 974
Keywords: natural rate of interest, learning, misperception, overreaction, dispersed information, long-term rates, demand shocks, monetary policy shocks
Classification-JEL: E43, E52, E58, D82, D83
Handle: RePEc:bis:biswps:974