The natural rate of interest depends on where you set natural real GDP

What if an economist expects the natural level of real output to be higher? How would the natural rate of interest change by expecting a lower natural rate of output?

First, I personally expect a lower natural limit upon real GDP. I see that real GDP is trending on a new normal level below the trend seen before the crisis. This graph presents my model for the interest rate as real GDP approaches the natural level of output. (The natural rate of interest is the equilibrium interest rate to keep output with stable inflation at the natural limit of real GDP.)

Update to fed rate path 5%

I see the natural level of output where capacity utilization multiplied by the employment rate is 73%. The violet and yellow lines are alternate paths that bound a zone for the Fed rate as real GDP is reaching this 73% natural level. The zone is positive at this point seen with the red dot getting close to this natural level of output (LRAS). A positive Fed rate would be prescribed. The down-sloping green line shows little spare capacity. However, the blue dot shows that the Fed rate is still on the ZLB (zero lower bound) implying that the Fed thinks the true zone is below 0%.

Now all I do in the above model is raise the demand constraint on the utilization of labor and capital (the demand constraint is the effective labor share anchor in the model). It seems many economists do not formally recognize a demand constraint. Be that as it may, I will change one variable, the demand constraint, from 73% to 78%, which would imply an unemployment rate of 5% and a capacity utilization rate of 82%. These are common enough expectations according to past data. (note: the z coefficient changes due to a change in the demand constraint.)

Update to fed rate path higher lras

All that is happening here is that the monetary framework shifted right from a lower natural level of real GDP to a higher one.

The new vertical curve is based on expectations of a higher natural level of real output, like the one seen before the crisis. But what happens to the prescribed Fed rate? The violet and yellow lines, which bound a zone for the Fed rate, have both gone negative for the current level of utilized labor and capital, -0.5% and -3.0% respectively. And on balance, they would stay negative for some time yet. The green line now shows much more spare capacity, over 8%.

So if you are an economist who says there is lots of spare capacity and expects real GDP to return to the level seen before the crisis, you would recommend “pedal to the metal” aggressive monetary policy, as Paul Krugman did yesterday. You want the Fed rate to be at the ZLB for a long time, at least until unemployment sits around 5.5%, which would correspond to roughly 76% on the x-axis.

If you are like me and expect real GDP to settle into a lower natural level of output, you would recommend a tighter monetary policy. It is a safer policy to raise the interest rate when nearing the natural real GDP vertical curve.