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Investment, interest rate policy, and equilibrium stability

  • Kurozumi, Takushi
  • Van Zandweghe, Willem

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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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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