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Declining Natural Rate of Interest

Paper Session

Sunday, Jan. 7, 2018 8:00 AM - 10:00 AM

Pennsylvania Convention Center, 202-A
Hosted By: American Economic Association
  • Chair: Heather Boushey, Washington Center for Equitable Growth

A Model of Secular Stagnation: Theory and Quantitative Evaluation

Gauti Eggertsson
,
Brown University
Neil Mehrotra
,
Brown University
Jacob Robbins
,
Brown University

Abstract

This paper formalizes and quantifies the secular stagnation hypothesis, defined as a persistently low or negative natural rate of interest leading to a chronically binding zero lower bound (ZLB). Output-inflation dynamics and policy prescriptions are fundamentally different from those in the standard New Keynesian framework. Using a 56-period quantitative life cycle model, a standard calibration to US data delivers a natural rate ranging from –1:5% to –2%, implying an elevated risk of ZLB episodes for the foreseeable future. We decompose the contribution of demographic and technological factors to the decline in interest rates since 1970 and quantify changes required to restore higher rates.

Understanding the New Normal: The Role of Demographics

Etienne Ganong
,
Federal Reserve Board
Benjamin K. Johannsen
,
Federal Reserve Board
David López-Salido
,
Federal Reserve Board

Abstract

Since the Great Recession, the U.S. economy has experienced low real GDP growth and low
real interest rates, including for long maturities. We show that these developments were largely predictable by calibrating an overlapping-generation model with a rich demographic structure to observed and projected changes in U.S. population, family composition, life expectancy, and labor market activity. The model accounts for a 1¼–percentage-point decline in both real GDP growth and the equilibrium real interest rate since 1980—essentially all of the permanent declines in those variables according to some estimates. The model also implies that these declines were especially pronounced over the past decade or so because of demographic factors most-directly associated with the post-war baby boom and the passing of the information technology boom. Our results further suggest that real GDP growth and real interest rates will remain low in coming decades, consistent with the U.S. economy having reached a “new normal.”

Demographics and Real Interest Rates: Inspecting the Mechanism

Carlos Carvalho
,
Pontifical Catholic University of Rio de Janeiro
Andrea Ferrero
,
University of Oxford
Fernanda Nechio
,
Federal Reserve Bank of San Francisco

Abstract

The demographic transition can affect the equilibrium real interest rate through three channels.
An increase in longevity—or expectations thereof—puts downward pressure on the real interest rate, as agents build up their savings in anticipation of a longer retirement period. A reduction in the population growth rate has two counteracting effects. On the one hand, capital per-worker rises, thus inducing lower real interest rates through a reduction in the marginal product of capital. On the other hand, the decline in population growth eventually leads to a higher dependency ratio (the fraction of retirees to workers). Because retirees save less than workers, this compositional effect lowers the aggregate savings rate and pushes real rates up. We calibrate a tractable life-cycle model to capture salient features of the demographic transition in developed economies, and find that its overall effect is a reduction of the equilibrium interest rate by at least one and a half percentage points between 1990 and 2014. Demographic trends have important implications for the conduct of monetary policy, especially in light of the zero lower bound on nominal interest rates. Other policies can offset the negative effects of the demographic transition on real rates with different degrees of success.
JEL Classifications
  • E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit