To determine whether a specific policy interest rate setting will stimulate or restrict the economy, central banks evaluate it relative to the Neutral Rate of Interest, commonly known as r-star (r)*.
Defining the Equilibrium Framework
The neutral rate is the theoretical real interest rate that supports sustainable economic growth at full employment while keeping inflation stable at the central bank’s target index. It represents an economy running at full capacity without generating inflationary heat or deflationary slowdowns: [1]
[Real Policy Rate > r-star] ---> Restrictive Stance -> Cools demand, dampens inflation pressures
[Real Policy Rate = r-star] ---> Neutral Policy Stance -> Maintains baseline structural economic metrics
[Real Policy Rate < r-star] ---> Accommodative Policy -> Stimulates credit expansion, fuels output
Because r-star cannot be measured directly, central bank quantitative teams must estimate it continuously using state-space models and filters, adjusting policy targets as productivity and population demographics shift over time.