The meaning of the neutral interest rate

The idea of a neutral interest rate emanates from the writings of the Swedish economist Knut Wicksell. According to Wicksell,

There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods.

In other words, the neutral rate of interest is defined as the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes. (Note that once the neutral rate is reached, the state of equilibrium is attained — implying that the economy is now well balanced and the price level is stable).

The main source of economic instability, it is held, is the variance between the money market interest rate and the neutral rate. If the market rate falls below the neutral rate, investment will exceed saving, implying that aggregate demand will be greater than aggregate supply. Assuming that excess demand is financed by an expansion in bank loans, this leads to the creation of new money, which in turn pushes the general level of prices up.

Conversely, if the market interest rate increases above the neutral rate, savings will exceed investment, aggregate supply will exceed aggregate demand, bank loans and the stock of money will contract, and prices will fall. Hence, whenever the market rate is in line with the neutral rate, the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level.

Again, this theory posits that deviations in the money market interest rate from the neutral rate is what sets in motion changes in the money supply which in turn disturb the general price level. Consequently, it is the role of the central authority to bring money market interest rates in line with the level of the neutral rate of interest.

According to this view, in order to establish whether monetary policy is tight or loose it is not enough to pay attention to the level of money market interest rates; rather one needs to contrast money market interest rates with the neutral rate. If the market interest rate is above the neutral rate then the policy stance is tight. Conversely, if the market rate is below the neutral rate then the policy stance is loose.

However, how is one to implement this framework? The main problem here is that the neutral interest rate can’t be observed. How can one tell whether the market interest rate is above or below the neutral rate?

Wicksell suggested that policy makers pay close attention to changes in the price level. A rising price level would call for an upward adjustment in the money market interest rate, while a falling price level would signal that the money market interest rate must be lowered.

According to the Wicksellian framework, in order to maintain price stability and economic stability, once the gap between the money market interest rate and the neutral rate is closed the central bank must at all times ensure that a gap does not re-emerge. In the Wicksellian framework a monetary policy that maintains the equality between the two rates becomes a factor of stability. But is this possible? After all, maintaining this equality means that the central bank would have to manipulate the supply of money, which in turn will only make things unstable. (In the present monetary system the Fed is actually directly engaged in the manipulation of the federal funds rate rather than money supply).

What the Fed is trying to achieve belongs to the world of a true free market economy. In a free market economy without a central bank, there would be no such thing as monetary policy. In the absence of central bank monetary policies the interest rates that emerge would be truly neutral.

Also, in a free market no one would be required to establish whether the interest rate is above or below some kind of imaginary equilibrium. In a free market, with the absence of money creation, there is no need for a policy to restrain increases in the price level.

The whole idea of the neutral interest rate is unrealistic insofar as we have a Fed that continuously tampers with interest rates and the money supply. Given the impossible goal that the Fed is trying to achieve, we do not expect Fed policy makers to become wise and all-knowing with regard to the correct level of the interest rate.

For a broader exposition of the ideas in this article, see this article, on which it is based.


  • Current says:

    In a free market, with the absence of money creation, there is no need for a policy to restrain increases in the price level.

    But whose to say that a free market in money would mean the absence of money creation?

    In a free market situation I don’t see how money creation can be prevented, if there is a demand for more money than exists then the market will find a way to supply it.

  • John Spiers says:

    Hello Current!

    How are you defining money? If you mean “medium of exchange” then by definition there is always enough money sufficient to the task. As a practical matter gold ore becomes coins and circulates until it is taken out of circulation to be converted into plate, decoration or jewelry, depending on demand. Demand does at times call plate decoration and jewelry back into coin, but otherwise what little comes out of the earth, when added to what available now, is negligible. Stability is one of many factors that recommends gold as money, defined as a medium of exchange.

    If you add “credit” to your definition, then certainly there will be no end to people offering such money, the flimsier the basis, the more on offer. But in a free market, loans are no more enforceable than bets, and we’d probably see such money evaporate as people begin to actually pay for things.

    • Current says:

      I’m in the process of writing an article about all this. So, rather than reply, if you wait for a week or so you can read the article.

  • I’m all in favour of a system in which neutral rates prevail. Implementing such a system is not difficult: in fact the system advocated by Abba Lerner (a contemporary of Keynes’s) with one variation would do the trick.

    Lerner’s system (which Keynes approved of) involved basically having the government / central bank machine create new money and spend it during recessions, and when inflation loomed, having the “machine” do the opposite: raise taxes and “unprint” or extinguish money. Lerner called this his “money pump”.

    One advantage of this system is that it cuts out the ridiculous paper chase that governments currently engage in: having Treasuries borrow money and issue bonds, with the central bank then buy up those bonds.

    My guess is that that system on its own would control demand OK, plus interest rates could be left to look after themselves.

    But Lerner still though it would be necessary to have governments or central banks influence interest rates. Doubtless it would be desirable to have the “interest rate adjusting” tool available for emergencies. But the main tool, it strikes me, should be the money pump, with interest rates left to look after themselves.

    There is a paper where Lerner sets out his ideas here:

  • vimothy says:

    Ralph, this is a recipe for third world levels of inflation. I can’t see how it has any advantages over the current system, imperfect thought it may be.

  • Vimothy, Why would Abba Lerner’s proposal be a “recipe for third world levels of inflation”? If you are suggesting his system enables politicians to get their hands on the printing press, my answer is that they already have a significant control over the press, and for two reasons.

    First, despite the nominal independence of the Bank of England, there is significant cooperation between the bank and politicians, particularly during the recent credit crunch. (Alistair Darling got the BoE to produce £60bn out of thin air for banks in trouble during the crunch.)

    Second, while in many jurisdictions it is only the central bank which can inject actual cash into the economy, politicians can inject something very near cash, that is government debt: govt debt near maturity is virtually the same as cash. Indeed, this has been a big problem recently: ballooning national debts.

    Also, it is debatable as to whether the degree of political control over “real cash printing” has much effect on inflation. While I favour as much independence as possible for central banks, Bill Mitchell produced evidence that there is no relationship between central bank independence and inflation. See chart here:

    And finally, it would be easy to have a set of rules governing what a central bank does and what elected politicians do which ruled out the possibility of politicians “printing debt” as above. To illustrate, one could have the bank responsible for the technical problem of determining whether inflation was too high or too low and hence whether government net spending should be increased or reduced. While elected politicians confined themselves to strictly political considerations, like the proportion of GDP grabbed by government and the make up of government spending.

    As to government borrowing, s*d it. Don’t have any. Just don’t do it. That’s my preferred option! Abba Lerner actually favoured a modest amount of government debt, but I don’t agree with him on that point, and nor do others. E.g. see this Huffington article by Warren Mosler (2nd last paragraph):

    Plus see this paper by Milton Friedman (p.250):

    • vimothy says:


      One reason (first noted by Friedman, in fact) is that the Phillips Curve relationship you want to exploit is not necessarily structurally invariant to your policy proposal. So instead of switching on the “money pump” (not a phrase that suggests conservative control of the money supply!) until inflation rises and unemployment falls, and then reversing the process counter-cyclically, you may find that, shortly after announcing your new policy, inflation rises of its own accord, and you have to reduce employment and output to reduce inflation.

      You write that, in practice, the separation of politicians from the printing press is not perfect, and I agree. However, I think it’s wrong to infer from this, as you seem to do, that separation is therefore unimportant. As such I don’t see how further weakening the barriers between them is an improvement. By what criteria, other than that it makes QE a bit easier to understand?

      I’m afraid that I don’t find Mitchell’s evidence on the relationship between central bank independence and inflation very convincing. He doesn’t specify his model, doesn’t reveal his method of estimation, doesn’t provide the results of his regression, doesn’t justify his criteria for sample selection, doesn’t test for statistical significance, joint significance, bias, heteroskedasticity, etc, etc. Furthermore, the paper he cites (Jacome & Vasquez, 2005), which is a rigorous empirical study, comes to rather more measured conclusions:

      The results obtained in this paper show a strong negative relationship between increased CBI and inflation, after controlling for international inflation, banking crises, and exchange regimes in the sampled countries. This conclusion is robust to the inclusion of an index of broader structural reforms, suggesting that the findings are not driven by an omitted variable bias. Furthermore, structural reforms are shown to have a beneficial effect on inflation, which illustrates the complementary nature of various dimensions of economic policies. The qualitative results are robust to three alternative measures of central bank independence. On the other hand, after taking into account the possible endogeneity of central bank reform, the paper fails to find a casual relationship running from CBI to inflation. Taken at face value, these results suggest that the extraordinary disinflation achieved in Latin America and the Caribbean during the 1990s cannot be attributed to the increased legal CBI. These findings, however, are subject to an important caveat, since the legal measures of CBI used in this paper may be poor indicators of the effective central bank autonomy in the conduct of monetary policy.

      “As to government borrowing, s*d it. Don’t have any. Just don’t do it. That’s my preferred option!”

      What is the advantage of this system over the one we have now? Govt spending is not constrained by need to repay debt?

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