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Investment, interest rate policy, and equilibrium stability

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  • Kurozumi, Takushi
  • Van Zandweghe, Willem

Abstract

Carlstrom and Fuerst [2005. Investment and interest rate policy: a discrete time analysis. Journal of Economic Theory 123, 4-20.] show that in the presence of investment activity and price stickiness, indeterminacy of equilibrium is induced by forward-looking monetary policy that sets the interest rate in response only to future inflation. In a stochastic version of their model, we find that this indeterminacy problem is due to a cost channel of monetary policy, whereby inflation expectations become self-fulfilling, and the problem can be overcome once the forward-looking policy responds also to current output or contains sufficiently strong interest rate smoothing, since this prevents the self-fulfilling expectations. We also show that when E-stability is adopted as the selection criterion from multiple equilibria, even the forward-looking policy generates a locally unique non-explosive E-stable fundamental rational expectations equilibrium as long as the policy response to expected future inflation is sufficiently strong.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 32 (2008)
Issue (Month): 5 (May)
Pages: 1489-1516

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Handle: RePEc:eee:dyncon:v:32:y:2008:i:5:p:1489-1516

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Web page: http://www.elsevier.com/locate/jedc

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References

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  1. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," CEPR Discussion Papers 1908, C.E.P.R. Discussion Papers.
  2. Linnemann, Ludger, 2006. "Interest rate policy, debt, and indeterminacy with distortionary taxation," Journal of Economic Dynamics and Control, Elsevier, vol. 30(3), pages 487-510, March.
  3. Klein, Paul, 2000. "Using the generalized Schur form to solve a multivariate linear rational expectations model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(10), pages 1405-1423, September.
  4. Honkapohja, Seppo & Mitra, Kaushik, 2004. "Are non-fundamental equilibria learnable in models of monetary policy?," Journal of Monetary Economics, Elsevier, vol. 51(8), pages 1743-1770, November.
  5. Carlstrom, Charles T. & Fuerst, Timothy S., 2004. "Learning and the central bank," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 327-338, March.
  6. Bill Dupor, 2000. "Investment and Interest Rate Policy," Econometric Society World Congress 2000 Contributed Papers 0007, Econometric Society.
  7. Kurozumi, Takushi, 2010. "Distortionary taxation and interest rate policy," Journal of Macroeconomics, Elsevier, vol. 32(1), pages 476-491, March.
  8. Xiao, Wei, 2008. "Increasing Returns And The Design Of Interest Rate Rules," Macroeconomic Dynamics, Cambridge University Press, vol. 12(01), pages 22-49, February.
  9. McCallum, Bennett T., 1998. "Solutions to linear rational expectations models: a compact exposition," Economics Letters, Elsevier, vol. 61(2), pages 143-147, November.
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  12. Charles T. Carlstrom & Timothy S. Fuerst, 2003. "Investment and interest rate policy: a discrete time analysis," Working Paper 0320, Federal Reserve Bank of Cleveland.
  13. Athanasios Orphanides, 2001. "Monetary policy rules, macroeconomic stability and inflation: a view from the trenches," Working Paper Series 115, European Central Bank.
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  15. Bennett McCallum, . "Multiple-Solution Indeterminacies in Monetary Policy Analysis," GSIA Working Papers 2003-E77, Carnegie Mellon University, Tepper School of Business.
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  18. Huang, Kevin X.D. & Meng, Qinglai, 2007. "Capital and macroeconomic instability in a discrete-time model with forward-looking interest rate rules," Journal of Economic Dynamics and Control, Elsevier, vol. 31(8), pages 2802-2826, August.
  19. Kurozumi, Takushi, 2006. "Determinacy and expectational stability of equilibrium in a monetary sticky-price model with Taylor rule," Journal of Monetary Economics, Elsevier, vol. 53(4), pages 827-846, May.
  20. Evans, George W. & McGough, Bruce, 2005. "Monetary policy, indeterminacy and learning," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 1809-1840, November.
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Citations

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Cited by:
  1. Huang, Kevin X.D. & Meng, Qinglai & Xue, Jianpo, 2009. "Is forward-looking inflation targeting destabilizing? The role of policy's response to current output under endogenous investment," Journal of Economic Dynamics and Control, Elsevier, vol. 33(2), pages 409-430, February.
  2. Kurozumi, Takushi, 2010. "Distortionary taxation and interest rate policy," Journal of Macroeconomics, Elsevier, vol. 32(1), pages 476-491, March.
  3. Takushi Kurozumi & Willem Van Zandweghe, 2008. "Labor market search and interest rate policy," Research Working Paper RWP 08-03, Federal Reserve Bank of Kansas City.
  4. Stephen McKnight, 2011. "Investment and interest rate policy in the open economy," Serie documentos de trabajo del Centro de Estudios Económicos 2011-02, El Colegio de México, Centro de Estudios Económicos.
  5. Takushi Kurozumi & Willem Van Zandweghe, 2011. "Determinacy under Inflation Targeting Interest Rate Policy in a Sticky Price Model with Investment (and Labor Bargaining)," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(5), pages 1019-1033, 08.
  6. Sosunov, Kirill & Khramov, Vadim, 2008. "Monetary policy rules and indterminacy," MPRA Paper 11996, University Library of Munich, Germany.
  7. Bennett T. McCallum, 2009. "The Role of "Determinacy" in Monetary Policy Analysis," IMES Discussion Paper Series 09-E-17, Institute for Monetary and Economic Studies, Bank of Japan.
  8. George Evans & Seppo Honkapohja, 2008. " Expectations, Learning and Monetary Policy: An Overview of Recent Research," CDMA Working Paper Series 0802, Centre for Dynamic Macroeconomic Analysis.
  9. John Duffy & Wei Xiao, 2011. "Investment and Monetary Policy: Learning and Determinacy of Equilibrium," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(5), pages 959-992, 08.
  10. Vadim Khramov, 2012. "Assessing DSGE Models with Capital Accumulation and Indeterminacy," IMF Working Papers 12/83, International Monetary Fund.

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