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rate of interest

created Oct 24th 2017, 12:28 by Akash Verma 2168



313 words
105 completed
By the natural rate, Wicksell meant that rate of interest at which commodity markets would be in equilibrium and prices would be stable. Interest rates lower than the natural rate would lead to excess demand and inflation while interest rates below the natural rate would lead to deflation.
A hundred years later, building on Wicksell’s idea of the natural rate, Stanford economist John Taylor developed a simple interest rate policy rule which came to be known as the Taylor Rule. The rule states that the nominal policy rate should be a function of the natural rate, the inflation rate, the difference between the logarithms of the actual and trend level of output or output gap, and the difference between the actual and target inflation rate.
The rule has been widely adopted by central banks all around the world though there are some challenges in applying the rule and there has been a long debate about it’s efficacy. However, as Taylor pointed out in his review at the Federal Reserve Bank of Boston conference last week, the rule has in fact been quite useful in helping central banks improve the effectiveness of their monetary policies. In the absence of an estimated Taylor Rule function, especially a neutral rate officially recognized by the RBI, it is not easy to apply the rule as a simple benchmark to assess whether the current repo rate is too high or too low. With the monetary policy committee (MPC) having recently lowered the repo rate to 6%, and an inflation rate of under 3.5%, the implied real neutral rate assessed by the MPC would appear to be around 2.5%. This is in the same ballpark as the neutral rate in advanced countries like the US. However, since the unemployment-underemployment rate in India is high relative to the advanced countries, the neutral rate should be lower in my view.

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