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Get the Lowdown: The International Side of the Fall in the U.S. Natural Rate of Interest

No. 403 (Revised February 2021)

Enrique Martínez-García

Abstract: I investigate the downward drift of U.S. interest rates from 1984:Q1 to 2019:Q4. For this, I bring the workhorse two-country New Keynesian model to data on the U.S. and an aggregate of its major trading partners using Bayesian techniques. I show that the U.S. natural (or equilibrium) interest rate recovered from the model has fallen more gradually than the long-run U.S. real rate, cushioned by productivity shocks. Since inflation expectations became well-anchored in the ‘90s, this implies that the continued interest rate decline is largely explained by the real rate tracking the natural rate downward. Foreign productivity spillovers have had significant effects on the U.S. natural rate and on U.S. output potential. However, foreign shock propagation contributed little to the upswing in U.S. output relative to potential or to sustaining inflation close to target, both of which are attributed almost entirely to mark-up compression (cost-push shocks) and an accommodative monetary policy in the U.S.

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