The Natural Rate of Interest (1)

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The notion of natural or normal magnitudes and values in economics refers to the results expected as the outcome of a specified institutional context. The relevant institutional context specified herein is a monetary system with a state (or tax-driven) currency and a floating exchange rate policy. There is significant historical and theoretical support for such a system’s relevance. It has been shown that in this context, the government budget will normally be in deficit, corresponding to net savings of financial assets in the non-government sectors. Deficit spending will result in net central bank reserve credits in the aggregate banking system, which will drive the short-term overnight inter-bank lending rate to zero. While government security sales may be used to drain the excess reserves to maintain some positive overnight rate, or the central bank may pay interest on reserve balances, absent such government intervention the base rate of interest is zero. In other words, the natural rate of interest is zero. As many other key rates of interest in the economy continue to follow the fed funds rate very closely, this will serve as the base rate in the economy, with markets determining the credit spreads 16 through risk assessment. Furthermore, there are a number of reasons why allowing the rate of interest to settle at its natural rate of zero makes good economic sense.

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