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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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I. Introduction 17


I. Introduction At the beginning of the 21st century, after the wide-scale collapse of centrally planned economies, the consensus perception prevails that prosperity and eco- nomic growth are generated by private enterprise and free markets. Neverthe- less, government policy has maintained its role as a major factor, responsible for creating the necessary conditions for promoting enterprise and growth. In this context, monetary policy has emerged as an important means for achieving these goals1. The arguments for this statement are twofold, concerning both how quickly and how accurately the intervention takes effect on the market. In the first place, unlike fiscal policy, which often serves multiple (sometimes conflict- ing) goals and may be subject to political influences and lengthy legislative de- cision-making and approval procedures, monetary policy conducted by an inde- pendent central bank can be adjusted relatively quickly to respond to the latest macroeconomic developments. Furthermore, the impact of monetary impulses especially on the financial markets under a sufficient degree of central bank credibility takes place immediately. Sometimes the financial market response even precedes the actual central bank intervention, as market participants antici- pate the envisaged measures and act accordingly in advance. The last decades have witnessed major transformations pertaining to both monetary policy theory and practice. Since the Bretton Woods collapse central banks exposed not only to a higher degree of freedom, but also to the need to define clear monetary policy goals and communicate them to the public. In the last two decades, a growing number of central...

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