The Neutral Rate

The neutral rate is rate of interest that neither spurs on nor slows down the underlying economy.

When policy rates are above the neutral rate, monetary policy is contractionary; when they are below the neutral rate, monetary policy is expansionary.

The neutral policy rate for any economy comprises two components:

Real trend rate of growth of the underlying economy, and

Long-run expected inflation.

An important aspect of monetary policy： the source of any shock to the inflation rate.

Demand shock (inflation rise caused by an increase in the confidence of consumers and business leaders), appropriate to tighten monetary policy in order to bring the inflationary pressures generated by these domestic demand pressures under control.

Supply shock (inflation caused by a rise in the price of supply). Raising interest rates might make a bad situation worse.