Presentation for the annual conference of Latvijas Banka by Jordi Galí, 20.09.2021

1. Three Consequences of a
Lower Equilibrium Interest Rate (r )
Jordi Galí
CREI, UPF and BSE
Bank of Latvia, September 2021
Jordi Galí (CREI, UPF and BSE) Consequences of a Lower r Bank of Latvia, September 2021 1 / 9

2. Three Consequences of a Lower r*
Decline in r , possibly permanent
- Brand and Mazelis, Holston et al.
- Lane: "a lot lower than it used to be"
Jordi Galí (CREI, UPF and BSE) Consequences of a Lower r Bank of Latvia, September 2021 2 / 9

3. Three Consequences of a Lower r*
Decline in r , possibly permanent
- Brand and Mazelis, Holston et al.
- Lane: "a lot lower than it used to be"
Consequence #1: less space for monetary policy
Consequence #2: more space for …scal policy
Consequence #3: more space for asset price bubbles
Jordi Galí (CREI, UPF and BSE) Consequences of a Lower r Bank of Latvia, September 2021 3 / 9

4. Less Space for Monetary Policy
On average
i = r + π
Impact of a lower r
) lower i, given an unchanged in‡ation target
) higher incidence of binding ELB episodes
) lower π on average
) need for a lower i, may not be feasible
If no change in strategy:
) inability to respond to adverse shocks
) de‡ationary pressures, higher volatility
Jordi Galí (CREI, UPF and BSE) Consequences of a Lower r Bank of Latvia, September 2021 4 / 9

5. Less Space for Monetary Policy
Andrade, Galí, Le Bihan and Matheron (forthcoming)
Quantitative analysis using an estimated DSGE model for the euro area
(i) optimal in‡ation target, given an unchanged policy rule
(ii) alternative rules consistent with 2% target being optimal
Key …ndings:
(i) a decline in r calls for a close to one-for-one (0.8) increase in the
in‡ation target
(ii) if r ' 1 then π ' 3%
Jordi Galí (CREI, UPF and BSE) Consequences of a Lower r Bank of Latvia, September 2021 5 / 9

6. 0 2 4 6 8 10 12
Annualized steady-state real interest rate
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
Optimal
inflation
target
(annualized)

7. Less Space for Monetary Policy
Andrade, Galí, Le Bihan and Matheron (forthcoming)
Quantitative analysis using an estimated DSGE model for the euro area
(i) optimal in‡ation target, given an unchanged policy rule
(ii) alternative rules consistent with 2% target being optimal
Key …ndings:
(i) a decline in r calls for a close to one-for-one (0.8) increase in the
in‡ation target
(ii) if r ' 1 then π ' 3%
Alternatives to a higher in‡ation target:
- more aggressive countercyclical …scal policies
- more aggressive "lower for longer" forward guidance
- adoption of make-up policies (ALT, PLT)
Caveats
Jordi Galí (CREI, UPF and BSE) Consequences of a Lower r Bank of Latvia, September 2021 6 / 9

8. Less Space for Monetary Policy
ECB Strategy Review:
(i) target "adjustment" too small, given size of r decline
(ii) no signi…cant adjustment in the policy rule (relative to existing
practice)
) Euro area = Japan Redux?
Jordi Galí (CREI, UPF and BSE) Consequences of a Lower r Bank of Latvia, September 2021 7 / 9

9. More Space for Fiscal Policy
Likely environment in the years to come:
r g
) stable debt dynamics
) room for aggressive countercyclical …scal policy
Consequence of " (g r) :
def p
= (g r) debt
) larger primary de…cit consistent with same debt ratio
) need for an adjustment of S&G parameters?
Important caveat: "reversal risk"
Jordi Galí (CREI, UPF and BSE) Consequences of a Lower r Bank of Latvia, September 2021 8 / 9

10. More Space for Asset Price Bubbles
Arbitrage equation for a bubble asset:
Et f∆QB
t+1/QB
t g = rt
) inconsistent with equilibrium if r > g, but not if r < g
) challenge for monetary policy (Galí 2014, 2021)
- ambiguous impact of MP on the bubble
- bubble useful to stimulate aggregate demand
Jordi Galí (CREI, UPF and BSE) Consequences of a Lower r Bank of Latvia, September 2021 9 / 9