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Interest Rate Policy and the Price Puzzle in a Quantitative Business Cycle Model

  • Schabert, Andreas

    (Department of Economics, University of Cologne)

In the empirical literature, monetary policy shocks are commonly measured as an innovation to a short-term nominal interest rate. In contrast, the majority of monetary business cycle models treats a broad monetary aggregate as the central bank's policy measure. We try overcome this disparity and present a business cycle model which allows to examine the effects of innovations to a non-contingent nominal interest rate rule. To obtain unique rational expectations equilibria we assume that changes in money supply are brought about open market operations. In addition to working capital, we consider staggered prices which enables real marginal costs to vary. Consistent with the empirical findings of Barth and Ramey (2000), the model predicts that real marginal cost and inflation rise in response to positive interest rate innovations. The mechanism corresponds to their 'Cost Channel of Monetary Transmission' and replicates typical monetary VAR results, including the puzzling behavior of prices.

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File URL: http://www.ihs.ac.at/publications/eco/es-95.pdf
File Function: First version, 2001
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Paper provided by Institute for Advanced Studies in its series Economics Series with number 95.

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Length: 22 pages
Date of creation: Feb 2001
Date of revision:
Handle: RePEc:ihs:ihsesp:95
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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.
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  3. Lawrence J. Christiano & Martin Eichenbaum, 1992. "Liquidity Effects and the Monetary Transmission Mechanism," NBER Working Papers 3974, National Bureau of Economic Research, Inc.
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  11. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
  12. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 1994. "The effects of monetary policy shocks: evidence from the flow of funds," Proceedings, Federal Reserve Bank of Dallas, issue Apr.
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  22. Casares, Miguel & McCallum, Bennett T., 2006. "An optimizing IS-LM framework with endogenous investment," Journal of Macroeconomics, Elsevier, vol. 28(4), pages 621-644, December.
  23. Carlstrom, Charles T. & Fuerst, Timothy S., 1995. "Interest rate rules vs. money growth rules a welfare comparison in a cash-in-advance economy," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 247-267, November.
  24. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
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