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

No. 403

Enrique Martínez-García

Abstract: Much consideration has been given among scholars and policymakers to the decline in the U.S. natural rate of interest since the 2007 – 09 global financial crisis. In this paper, I investigate its determinants and drivers through the lens of the workhorse two-country New Keynesian model that captures the trade and technological interconnectedness of the U.S. with the rest of the world economy. Using Bayesian techniques, I bring the set of binding log-linearized equilibrium conditions from this model to the data, but augmented with survey-based forecasts in order to align the solution with observed expectations incorporating the macro effects of the zero-lower bound constraint. With this structural framework, I recover a novel open-economy estimate of the U.S. natural rate. The paper’s main results are: (a) the decline in the U.S. natural rate largely follows the slide of the long-run real interest rate in the forecast data, but is partly cushioned in the short run by the contribution of domestic and to a significant extent also foreign productivity shocks; (b) the fall of U.S. measured labor productivity during this time contributed to a concomitant fall in U.S. output potential; (c) the past decade is also characterized by the compression of markups (negative cost-push shocks) which accounts for much of the cyclical upswing in U.S. output in spite of the fall in its potential; and (d) monetary policy has shown its efficacy boosting U.S. output and sustaining U.S. inflation close to its 2 percent target against the drag on inflation from the negative cost-push shocks during this time. Finally, I also argue that ignoring the international linkages may result in biased estimates and can distort the empirical inferences on U.S. monetary policy in important ways.

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