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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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IV. Shock impulse responses 81


IV. Shock impulse responses In Chapter III, I studied the determinacy properties of different interest rate rule specifications with respect to the degree of activeness of the rule (measured by the inflation coefficient) and the target variables included were assessed within a New Keynesian framework with endogenous capital and adjustment costs. Based on the results obtained, I will now assess the characteristics of the con- vergence path back to steady state after a shock occurs, implied by active and passive rules under three possible specifications for each class: (i) rules with a sole inflation target; (ii) rules with an inflation and output target and (iii) rules with inflation and output gap target and interest-rate smoothing. The types of shocks entering the impulse responses are threefold: (i) a monetary policy unit shock; (ii) a technology unit shock and (iii) a consumption preference shock. In the subsequent analysis, policy rule specifications that yield determinacy of rational-expectations equilibrium (REE) and in addition involve quantitatively smaller deviations and fast, monotonic convergence path after a shock occurs would be preferred. The chapter is organised as follows. Section 1 provides some general pre- liminary insights to the adjustment mechanisms in the system as a result of three types of shocks (monetary policy unit shock, technology unit shock and con- sumption preference unit shock) and identifies the two main transmission chan- nels in the model (the real interest rate and the real marginal cost channel). Then in Sections 2 and 3 the adjustment paths of consumption, investment,...

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