The real interest rate gap as an inflation indicator

Quarterly Bulletin
Published on 01 June 2001

By Katharine S Neiss and Edward Nelson

In this paper, we investigate the business cycle properties of the real interest rate relative to its natural value. Our investigation into the natural real interest rate is motivated by the possibility of constructing a measure of monetary policy stance based exclusively on interest rates. Recent work by Michael Woodford has revived the ideas of Knut Wicksell by focusing on ‘the gap between the current level of the ‘natural rate’ of interest and the interest rate controlled by the central bank’ as the key variable for the analysis of ‘inflationary or deflationary pressures’. In line with this terminology, we describe the spread between actual and natural real interest rates as the real interest rate gap.

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