A Neutral Real Interest Rate in the Case of a Small Open Economy: Application to Ukraine

Abstract

This paper measures a neutral interest rate in Ukraine by means of applying a Kalman filter to a semistructural model with unobserved components. We rely on a medium-term concept of a neutral interest rate, where it is defined as a real interest rate consistent with output at its potential level and inflation at its target level after the effects of all cyclical shocks have disappeared. Under this concept, and accounting for the small open nature of Ukrainian economy, the neutral interest rate is determined by the global economy's cost of capital and domestic long-term factors that influence risk-premium and changes in the real exchange rate. Conditional on long-term forecasts for output, demographic trends, real exchange rate changes and risk premium, the neutral rate is projected to decrease gradually from its 2.5% level as of the beginning of 2018 to 2% in real terms, or to 7% in nominal terms under a 5% inflation target. However, in the following years the gap between the National Bank of Ukraine's policy rate and the neutral rate should remain positive -reflecting the tight monetary stance needed to ensure stable disinflation. JEL Codes C32, E43, E52

Estimating the Neutral Interest Rate in the Kyrgyz Republic

“…The QPM estimates a real neutral rate of 3.7 for the end-2019. The real neutral rate is higher than in other emerging markets (1 percent in the Czech Republic (Hledik, Vlcek, 2018), 2 percent in Georgia (IMF, 2018), 2.5 percent in Ukraine and 2.5-3.5 percent in the Russian Federation (Grui, Lepushynskyi and Nikolaychuk, 2018), but similar to Kazakhstan's and Brazil's (in the 4-5.5 percent range).…”

“…• Most studies estimate neutral rates for developed economies, while a few investigations pursued neutral rates for emerging markets and developing countries. Grui, Lepushynskyi and Nikolaychuk (2018)…”

Problems of estimating the neutral interest rate: conclusions for Ukraine

“…At the same time, Grui et al (2018) indicate that the UIP method is optimal for a small open economy. They define the real neutral rate as a combination of the influence of factors such as the neutral rate in the United States, the sovereign risk premium and the devaluation trend of REER within the semi-structural model of the economy.…”

“…The method for estimating the neutral interest rate based on the UIP rule (UIP-method) reflects the prioritization of external impact on investment processes in the domestic economy. This is the approach that is used by the National Bank of Ukraine (NBU) (Grui et al, 2018).…”

“…REER, according to the Harrod-Balass-Samuelson effect, can indicate a change in productivity only in the long run, while in the medium and short run it is not so (Chong et al, 2012). However, Grui et al (2018) conceptually do not distinguish between the factors of REER and economic productivity and, therefore, conclude that productivity growth leads to a reduction in the neutral value of money, which contradicts the basic concept of neutral rate in the interpretation of Woodford (2003) and Laubach and Williams (2003), where the demand for money generated by the growth of potential GDP should raise the price of money.…”