The Natural Rate of Interest and Convergence

We explore the natural rate of interest, shortly r*, in emerging economies. If economic growth originates from convergence, then growth, say, from technological progress will be lower than we find in the data and, hence, r* will be lower. Ignoring convergence upwardly biases our estimates of r*. We extend the New Keynesian small open economy model to incorporate convergence effects and estimate it using Bayesian techniques for four emerging economies in Central and Eastern Europe: Poland, Czech Republic, Hungary and Romania. Empirical evidence of the rapid catching-up of our sample economies during the period from 2003 to 2019 assists in specifying the model estimation. Our findings confirm a decline in r* over the past decades. Accounting for capital deepening reveals meaningful differences in estimated r*, with non-negligible implications for monetary policy in emerging economies.