goes back to wicksell. he defined it as the level of the real interest rate at which prices have no tendency to move either upward or downward. the starting point of his analysis is the assumption that any movement in the price of a single good must have been caused by a mismatch between the demand for and the supply of this particular good. accordingly, the movement of the aggregate price level must have been caused by a mismatch between aggregate demand and aggregate supply. wicksell therefore stressed that any theory which intends to explain the overall rate of inflation must therefore be able to explain the underlying aggregate demand and supply movements. a second important aspect of wicksell ’ s theory is related to the role of money and credit. he did not doubt that money growth is a necessary condition for inflation, but his approach is based on the endogeneity of money – in other words, money is not exogenous. here, the banking system plays the crucial role : by extending credit to firms and households it determines the growth rate of money and thereby aggregate demand. key to the understanding of this connection is wicksell ’ s ’ cumulative process ’. banks setting ‘ too low ’ an interest rate trigger a high credit demand from investors because, given the relatively low interest rate costs, they have a high expected return. owing to the prevailing very large degree of flexibility in the banking sector, banks can satisfy this higher loan demand, which results in an increase in money growth and a higher demand for investment goods. this tends to increase the price level of investment goods and the competitive wages in the investment goods sector, causing expenditures and the overall price level to rise. this is how shackle describes the next steps in wicksell ’ s cumulative process : “ the cost of production per physical unit of goods will be rising month by month, but the price of goods per unit will be rising as fast, will be keeping ahead, and the persisting gap per unit will invite an ever - larger output ”. 1 the cumulative process of strong money creation by a highly flexible banking system and a higher aggregate price level does not end until the banks have raised the interest rate sufficiently. here, ‘ sufficiently ’ means that the interest rate – which is set by the banks – should be raised to the level at which the overall demand for goods equals their supply – that is, the interest rate at which prices remain constant. wicksell referred to this interest rate level as the ‘ natural rate of interest

of orphanides and williams ( 2002 ) : they show that the welfare cost of underestimating the degree of mismeasurement of the natural rate of interest 20 exceeds the cost of overestimating it. put differently, a policy that is optimal for the case of low measurement uncertainty would induce large welfare losses if measurement uncertainty is, in fact, high, but would bring about only moderate losses in efficiency in the converse case. accordingly, the robust policy rule puts little weight on the estimate of the natural rate. in the extreme, robust optimal policy would ignore it completely and go for a policy rule that relies on first differences of observed variables rather than the relevant gaps. 21 summing up and looking ahead this example illustrates that on top of all those statistical measurement problems the question of how to react optimally to an estimate of the natural rate may be an even more intricate problem. so at the end of the day, what can we make of the concept of the natural real rate of interest for the practice of monetary policy? to answer this question, let me come back to the properties for an ideal benchmark indicator of the monetary policy stance, which i listed at the beginning. first, concerning theoretical foundations, the natural real rate of interest – with an already long tradition in economic theory – plays a key role in modern rational - expectations models of monetary macroeconomics and stands on sound analytical ground. it is a tool for thinking about the monetary transmission process. this is because the determinants of the natural rate of interest – for example changes in preferences, advances in production technology and variations in government spending – all have an effect on output fluctuations and inflation. thus, the natural rate of interest subsumes all these real shocks into a single number that – when compared with the actual real rate – provides an indicator for the stance of monetary policy. second, even within the limits of the theoretical framework, the corresponding interest rate gap is not a sufficient summary variable reflecting the overall pressure on inflation in the sense that it captures all see angeloni, smets and weber ( 1999 ) and the references therein concerning the problem of monetary policy making under uncertainty with special reference to ecb policy. shackle ( 1972 ), p. 240. thus, compared to the latter considerations, model uncertainty in a quite narrow sense. they are concerned with both the natural rate of interest and the natural rate of unemployment. orphanides and williams even propose a policy rule that completely dismisses any reliance on natural rate