Question

Knowing r* (The “natural” rate of interest) is sufficient to pursue an effective monetary policy? Discuss this statement.

Answer 1

Knut Wicksell introduced the theory of a natural real rate of interest. It stated that r* (The “natural” interest rate) to be linked with marginal capital productivity that, in combination with market rates of interest will determine price dynamics. There would be rise in prices when the market rates were below the natural rate, and prices would fall should the opposite be the case. When market rates are influenced with the monetary policy and somehow linked to monetary aggregates, the theory presents a reformulation of the quantity theory of money adapted to a money/credit economy. Thus it can be concluded that natural real rate of interest is enough to pursue an effective monetary policy.