Natural Interest Rate

What Is The Natural Interest Rate?

The natural rate of interest is a hypothetical interest rate at which the economy is at its maximum output capacity with full employment and a stable inflation rate. This interest rate aims to act as a reference point for central banks and policymakers in forming the monetary policies in an economy.

This interest rate is also known as the neutral rate of interest and the long-run equilibrium interest rate. It is because it determines the level at which the demand for borrowing and the supply of savings in an economy is in an equilibrium state. As a result, the economy experiences price stability and full employment GDP. 

• The natural rate of interest is a theoretical interest rate at which the economy is in a state where the output is at its maximum, the prices and inflation rate are stable, and there is full employment. It occurs when the demand for borrowing and the supply of savings are in equilibrium.
• Also known as the neutral interest rate and long-run equilibrium interest rate, the natural interest rate acts as a reference value for the central banks and policymakers in formulating monetary policy.
• This interest rate represents the dynamics between lenders and borrowers in an economy.

Natural Interest Rate Explained

The natural rate of interest is the hypothetical interest rate at which the borrowing demand and the lending supply are in equilibrium in an economy. As a result, the economy is at its maximum output capacity with price stability, full employment GDP, and a stable inflation rate. This interest rate represents the dynamics between the borrower and lenders in an economy.

The natural rate acts as a valuable instrument for policymakers and the central bank. They use it as a standard value for formulating monetary policy in an economy. To achieve economic stability, policymakers try to set the actual interest rates as close to the natural rate as possible. A significant disparity between actual and natural rates could create an imbalance in the economy and disrupt the optimum financial activity levels.

Factors

The neutral rate factors are as follows:

• The availability of profitable investment opportunities and the economic productivity level influences the natural rate. A high productivity level and vast pool of profitable investment opportunities result in a lower neutral interest rate as they decrease the borrowing demands and increase the savings supply.
• The monetary policy that the central banks formulate can impact this interest rate. When the central banks expect a high inflation rate in the future, the lenders may demand a higher interest rate to compensate for the decreasing value of money, which will lead to a higher natural rate.
• The fiscal policy the government implements, like government spending and taxation, impacts the natural rate. A higher tax will reduce savings and disposable income, resulting in a higher natural rate. However, a lower tax will increase savings and disposable income, leading to a lower natural rate. 

Formula

The Laubach-Williams model, established in 2003, is a valuable tool used for measuring the natural rate of interest. This model offers a method to quantify the equilibrium interest rate that would lead to an economy having a maximum output at full employment with a stable inflation rate. This model assumes that the natural interest rate can be determined as the sum of various economic factors and a trend component.

The model considers several long-term factors like population rise and productivity trends to estimate the trend component. Meanwhile, the economic factors are evaluated by considering short-term factors like the output gap and inflation deviations. The model suggests that these factors consistently impact the natural rate over time. The Laubach-Williams model is instrumental in the natural rate of interest estimation through a deeper understanding of its dynamics and relationship with various economic factors. 

Examples

Let us understand this concept with the following examples:

Example #1

Suppose the United States has a 5% base rate, leading to a situation where the inflation rate is stable at 2%. The economy is growing at a 2.5% rate, implying that the nominal natural interest rate is 5% while the natural rate is 3%. However, a sudden increase in demand results in higher inflation. The inflation rate increases to 4%, and the economic growth rate rises to 4% consecutively. To decrease the inflation, the central bank raised the interest rates to 7%. Due to this change, the inflation rate decreases back to 2%, and economic growth to the 2.5% target.

Example #2

On May 19, 2023, John Williams, the President of the Federal Reserve Bank in New York, said that the United States and other major economies have a low natural interest rate despite the pandemic and its impact on the inflation surge. This interest rate was historically low before the pandemic occurred. As a result, the central bank kept its interest rate target at low levels. However, the low natural interest rate remained in place even after the pandemic and its aftermath, where inflation rates increased dramatically.

Importance

The importance of this interest rate is as follows:

• The natural rate is a reference value for central banks and policymakers to attain economic stability. An actual interest that aligns with this rate can help mitigate deflationary and inflationary pressure, increase price stability, and aid in promoting economic growth.
• This interest rate can offer crucial insights into the economy's current state and its future trends. It is a valuable tool for analysts and economists to forecast various economic patterns and analyze the consequences of monetary policy decisions. It can assist in deeply understanding the factors that lead to economic growth and help plan and formulate policies to achieve long-term financial objectives.
• The neutral rate can impact individuals' and businesses' saving and investment decisions. An actual rate higher than the natural rate deters borrowing and investment, resulting in a slowdown. However, when the natural rate exceeds the actual rate, individuals and businesses start borrowing and investing, which fuels economic activity. This rate aids in making informed financial decisions.

Natural Interest Rate vs Market Interest Rate

The differences are as follows:

• Natural Interest Rate: This interest rate aims at balancing the demand for borrowing and supply for saving in an economy, which helps stabilize prices and results in total employment. It depends on several factors, like investment opportunities and productivity. Furthermore, long-term economic factors like demographics, investment, and saving behavior impact it. It acts as a standard for central banks and other policymakers where they align the policy rates with the natural rates to reach maximum output and economic stability. This interest rate is also called the neutral interest rate, neutral rate, and long-run equilibrium interest rate.
• Market Interest Rate: This is the rate at which borrowers get loans and lenders receive interest or returns on their investments in the financial market. Several factors influence it, like the market forces of demand and supply, central bank policies, credit conditions, and expected inflation rates. And borrowers get loans. It is also known as the actual or observed interest rate.

Frequently Asked Questions (FAQs)

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