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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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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," NBER Working Papers 8403, National Bureau of Economic Research, Inc.
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  8. 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.
  9. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  10. Kevin X.D. Huang & Qinglai Meng, 2007. "Is Forward-Looking Inflation Targeting Destabilizing? The Role of Policy's Response to Current Output under Endogenous Investment," Vanderbilt University Department of Economics Working Papers 0704, Vanderbilt University Department of Economics.
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  15. 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.
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  18. 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.
  19. Charles T. Carlstrom & Timothy S. Fuerst, 2001. "Learning and the central bank," Working Paper 0117, Federal Reserve Bank of Cleveland.
  20. Carlstrom, Charles T. & Fuerst, Timothy S., 2005. "Investment and interest rate policy: a discrete time analysis," Journal of Economic Theory, Elsevier, vol. 123(1), pages 4-20, July.
  21. McCallum, Bennett T., 2003. "Multiple-solution indeterminacies in monetary policy analysis," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 1153-1175, July.
  22. Frank Smets & Raf Wouters, 2002. "An estimated dynamic stochastic general equilibrium model of the euro area," Working Paper Research 35, National Bank of Belgium.
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