Ties that bind: Estimating the natural rate of interest for small open economies

Abstract

This paper estimates the natural rate of interest for six small open-economies (Australia, Canada, South Korea, Sweden, Switzerland, and the U.K.) with a structural New Keynesian model using Bayesian techniques. Our empirical analysis establishes the following four main findings: First, we show that the open economy framework provides a better fit of the data than its closed economy counterpart for the six countries we investigate. Second, we also show that, in all six countries, a Taylor (1993)-type monetary policy rule that tracks the Wicksellian short-term natural rate fits the data better than a rule that does not. Third, we show that the natural interest rates of all six countries have shifted downwards and strongly co-moved with each other over the past 35 years. Fourth, our findings illustrate that foreign output shocks (spillovers from the rest of the world) are a major contributor to the dynamics of the natural rate in these six small open-economies and that those natural rates strongly comove also with the existing U.S. natural rate estimates.