No abstract

No abstract

Although it is generally recognized that the equilibrium real interest rate (ERR) varies over time, most recent work on policy analysis has been carried out under the assumption that this rate is constant. We show how this assumption can affect inferences about the conduct of policy in two different areas. First, if the ERR moves in the same direction as the trend growth rate (as is suggested by theory), the probability that an unperceived change in trend growth will lead to a substantial change in inflation is noticeably lower than is suggested by recent analyses (of inflation in the 1970s, for example) that assume a constant ERR. Second, if the monetary authority targets a time varying ERR but the econometrician assumes otherwise, estimated policy rules will tend to exaggerate the degree of interest rate smoothing as well as the weight that the monetary authority places upon inflation. JEL Classification: E52 * We would like to thank Kevin Lansing and Glenn Rudebusch for helpful comments as well as Mike Atkinson for outstanding research assistance. The views expressed in this paper do not necessarily reflect those of the Federal Reserve Bank of San Francisco or the Federal Reserve System.

No abstract

We show how a positive correlation between the equilibrium real interest rate (ERR) and trend growth matters for two widely debated issues in monetary policy. First, a simple Taylor rule is more robust to uncertainty about the trend growth rate than suggested by some analyses of the increase in U.S. inflation during the 1970s, because the policy mistake made when measuring the change in trend growth gets offset by the accompanying mistake in measuring the change in the ERR. Second, ignoring this correlation when estimating policy rules results in coefficients that exaggerate both the degree of interest rate smoothing and the strength of the monetary authority's response to inflation. r