Interest, Neutral Rate of

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Interest, Neutral Rate of

The neutral rate of interest is, in modern parlance, the short-term interest rate that minimizes the gap between the actual and the potential output of the economy while keeping inflation close to zero. At that interest-rate level money is considered to be neutral in the sense that monetary policy does not exert any distinct influence on economic activity other than fulfilling its primary tasks of preserving a stable value of money and safeguarding the financial system.

The concept of the neutral rate of interest provides a benchmark for modern central banking in accordance with the core model of the new neoclassical synthesis, the mainstream framework for macroeconomic policy analysis that has replaced the IS-LM model. The new synthesis is based on the concept of a natural rate of output, which is the potential output that would be realized in an equilibrium with flexible wages and prices. The corresponding natural rate of interest keeps the output gap at a minimum. In an environment with sticky wages and prices this can be achieved only if inflation is minimized, such that the stickiness does not matter. Hence the term natural rate of interest is often used as synonymous with the neutral rate. Michael Woodford’s key contribution to the new synthesis, his Interest and Prices (2003), is a prominent example (though it has few explicit references to neutrality).

However, caveats and objections have been raised, both to defining the neutral rate of interest in terms of inflation and output gap minimization, and to equating the neutral rate with the natural rate. The most relevant objections can be traced back to the very origin of neutral-rate concepts in Knut Wicksell’s Interest and Prices :

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital (1898, p. 102).

Wicksell’s definition of neutral and natural rates of interest comprises three characteristics: price-level stability, capital market equilibrium, and the correspondence of barter lending to monetary equilibrium. The first characteristic implies zero inflation. The second characteristic requires that real investment (demand) equals saving (supply). The third characteristic is the claim that credit relations in monetary economies can be studied as if they were credit relations in economies where transactions are made in kind (in natura, hence the expression “natural rate”). A fourth characteristic, also contained in Wicksell’s Interest and Prices, is the proposition that market systems tend to gravitate toward the natural rate of interest. As the representative monetary rate of interest converges on the natural rate, it becomes neutral with respect to the level and structure of real economic activity. This proposition is at the core of postulates of the (long-run) neutrality of money and has become a defining criterion for modern natural-rate concepts (such as the natural rate of unemployment).

In the early 1930s two followers of Wicksell, Erik Lindahl and Gunnar Myrdal, demonstrated that, in non-stationary monetary economies with more than one good, the expected rate of return on real investment cannot be determined independently of the monetary loan rate of interest. Hence they rejected the third characteristic of Wicksell’s definition. Lindahl, Myrdal, and August Friedrich Hayek also argued that the absence of inflation does not necessarily imply that the underlying rate of interest is neutral. Interest-rate gaps, that is, discrepancies between loan rates and the rates of return to real investment, could lead to investment activities that change the capital stock, and hence the structure and level of the production, in such a way that the price level remains unchanged. Conversely, as Lindahl pointed out, a “neutral rate of interest does not necessarily imply an unchanged price level, but rather such a development of prices as is in accordance with the expectations of the public” (1930, p. 252). Wicksell’s first characteristic of the neutral rate and key ingredient of its modern definition was thus put into doubt. On the base of all these arguments, Lindahl and Myrdal (though not Hayek) refuted Wicksell’s fourth characteristic, the gravitational force of the natural rate. They argued that the equilibrium rate of return to real investment is influenced by past monetary policy through the latter’s effect on market rates of interest and capital valuation. Thus money is not automatically neutral.

The only characteristic of Wicksell’s neutral-rate concept that survived the scrutiny of Lindahl and Myrdal was the criterion of capital market equilibrium in the sense of planned investment equalling planned saving. Even this criterion came under attack when the English economist John Maynard Keynes published his The General Theory of Employment, Interest and Money (1936). In Keynes’ system, as in the conventional IS-LM framework that was subsequently developed from it, the market rate of interest does not coordinate investment with saving ex ante, but saving adjusts to investment ex post, through the latter’s multiplier effect on income. Saving thus equals investment at different levels of interest and income, and Keynes concluded that there is no unique “natural” or equilibrium rate of interest. The only rate of interest that is “unique and significant … must be the rate which we might term the neutral rate of interest, namely, the natural rate … which is consistent with full employment” (1936, p. 243). More strictly defined, the neutral rate of the interest is the rate that “prevails in equilibrium when output and employment are such that the elasticity of employment as a whole is zero” (p. 243). Whether a zero elasticity of employment is identical with potential output, and whether the latter can be described by the natural rate of unemployment has been a matter of much dispute ever since the debates about the Phillips Curve, the suggestion of a trade-off between inflation and unemployment, started in the 1960s. That the old caveats concerning the neutral rate of interest are ignored in its modern definitions is not necessarily a sign of scientific progress. It is largely due to a shift toward models of intertemporal general equilibrium in terms of continuous optimization of representative agents. Such modelling strategies simply have no room for the problems in the coordination of investment and saving decisions that were at the heart of older debates about the neutral rate of interest.

SEE ALSO Employment; Full Employment; Inflation; Interest, Natural Rate of; Interest, Own Rate of; Interest Rates; Involuntary Unemployment; Keynes, John Maynard; Phillips Curve; Unemployment