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Interest-Rate Rules in a New Keynesian Framework with Investment


Elena Pavlova

The last decades have witnessed major progress in both monetary policy theory and practice, with broad academic consensus on the desirability of monetary policy rules and ongoing research on their exact specification. Typically, the analysis is carried out in a New Keynesian framework with nominal rigidities and constant capital stock. The latter represents a constraint that this study seeks to overcome by introducing a model with investment and capital adjustment costs. The work assesses different interest-rate rule specifications with respect to the target variables included, based on two criteria: determinacy of rational-expectations equilibrium and convergence to steady state after a shock. The study concludes that rules with both an inflation and an output gap target ensure a unique rational-expectations equilibrium and a less distressful adjustment of the economy after the occurrence of shocks.


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Table of Contents


List of Figures and Tables List of Symbols I. Introduction II. Monetary policy design and criteria for assessing monetary policy rules 1. Monetary policy issues 1.1. The case for rules rather than discretion 1.1.1. Analytical distinction between rules and discretion 1.1.2. The problem of dynamic inconsistency 1.1.3. Advantages of central bank commitment to a monetary policy rule 1.2. Design of monetary policy rules 1.2.1. Rules, instruments and targets 1.2.2. Choice of instruments 1.2.3. Choice of target variables 2. Criteria for assessing monetary policy rules 2.1. Operationality/Simplicity 2.2. Local determinacy of rational-expectations equilibrium and monetary policy analysis 2.2.1. An overview 2.2.2. Presenting the criterion 2.2.3. Determinacy and reactions to shocks 2.3. The Taylor principle 3. Preliminary summary III. A New Keynesian model with endogenous capital with adjustment costs 1. New Keynesian framework: an overview 2. Modelling capital and investment 3. The model with endogenous capital and adjustment costs 11 13 17 21 21 23 23 24 25 26 28 30 31 37 38 41 41 42 43 45 49 51 52 55 60 3.1. Household utility function and optimality conditions 3.2. The “IS sector” 3.3. Capital accumulation adjustment costs 3.4. Inflation and real wage equations under sticky prices and wages 3.5. Interest-rate rule specifications 4. Determinacy analysis 4.1. Calibration 4.2. Determinacy and the Taylor principle: some numerical examples 4.2.1. Active rule 4.2.2. Passive rule 4.2.3. Interest-rate rule response coefficient values and determinacy: a global perspective 5. Preliminary summary of results IV. Shock impulse responses 1. Some preliminary remarks on the adjustment...

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