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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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II. Monetary policy design and criteria for assessing monetary policy rules 21


II. Monetary policy design and criteria for assessing monetary policy rules In this chapter, I provide a more general perspective to the main theoretical and practical issues in monetary policy design, which are relevant for the assessment of the several interest rate rule specifications in the subsequent parts. The issues covered in Section 1 include the advantages and implications of systematic pol- icy behaviour (as opposed to discretionary measures) and choice of instru- ments/target variables that enter the rule specification. In addition, Section 2 presents the main criteria that will be used in the subsequent determinacy and impulse response analysis in Chapters III and IV. The Taylor principle, which forms the basis for the classification of monetary policy rules in terms of the de- gree of their “activeness” (measured by the size of the inflation response coeffi- cient), is presented formally in the last subsection. Later on, in Section 4 in the subsequent chapter the main findings will be centred on the question whether adherence to the Taylor principle guarantees a determinate rational-expectations equilibrium when endogenous capital with adjustment costs is introduced to a New Keynesian model with staggered price-and wage-setting. 1. Monetary policy issues In the 1960s and 1970s “activist” monetary policies, aimed at achieving “full employment” have been widely discussed and implemented5. The rise of such policies has been motivated by the conviction that there exists a stable long-run trade-off between inflation and unemployment, captured by the Phillips curve6. According to this view, in the long run the...

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