Credit and the Natural Rate of Interest


  • The views expressed here are personal and do not necessarily reflect those of the European Central Bank or the Eurosystem. We wish to thank an anonymous referee, Liam Graham, and Philippe Weil for useful comments, as well as seminar participants at the ECB, the Bank of Portugal, the EEA meeting (2007), the SCE meetings (2007), and the Bank of Finland/CEPR Conference on “Credit and the Macroeconomy.” We are particularly grateful to Michael Woodford for extensive comments and discussions.


We analyze the properties of the natural rate of interest in an economy with asymmetric information between borrowers and lenders, and nominal debt contracts. In our model, monetary policy has real effects in the flexible-price equilibrium because it affects the cost of external finance. As a consequence, under the standard definition, the natural rate of interest is not a useful policy indicator because it is itself affected by monetary policy. We propose a generalized definition and demonstrate that the resulting natural rate (i) is not policy dependent and (ii) delivers price stability if used as the intercept of a monetary policy rule. From a qualitative perspective, the dynamics of the natural rate in response to shocks can be very different in economies with or without financial frictions. Quantitatively, the policy implications of these differences tend to be minor for real shocks, but sizable for financial shocks of the magnitude observed during the financial crisis of 2007–09.