Working Paper

Monetary policy and the behavior of long-term interest rates

Abstract: Real output is strongly correlated with the short-term nominal rate of interest. However, standard models of aggregate demand suggest that real output should be correlated with an expected long-term real rate of interest. We argue that the observed output-nominal rate correlation is an artifact of monetary policy. The systematic behavior of monetary policy, in combination with sluggish inflation adjustment and a structural IS curve that relates output to the rationally expected long-term real rate of interest, has made the sample path of the long-term real rate look like the short-term nominal rate. Thus the statistical correlation between the nominal rate and output arises in the interaction of monetary policy with the rest of the macroeconomy; it is not a structural relationship that policy is free to exploit.

Keywords: Interest rates; Vector autoregression; Monetary policy;

Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Papers in Applied Economic Theory

Publication Date: 1993

Number: 93-05