Interest-Rate Rules in a New Keynesian Framework with Investment by Elena Pavlova

I. Introduction 
At the beginning of the 21st century, after the wide-scale collapse of centrally 
planned economies, the consensus perception prevails that prosperity and eco-
nomic growth are generated by private enterprise and free markets. Neverthe-
less, government policy has maintained its role as a major factor, responsible for 
creating the necessary conditions for promoting enterprise and growth. In this 
context, monetary policy has emerged as an important means for achieving these 
goals. The arguments for this statement are twofold, concerning both how 
quickly and how accurately the intervention takes effect on the market. In the 
first place, unlike fiscal policy, which often serves multiple (sometimes conflict-
ing) goals and may be subject to political influences and lengthy legislative de-
cision-making and approval procedures, monetary policy conducted by an inde-
pendent central bank can be adjusted relatively quickly to respond to the latest 
macroeconomic developments. Furthermore, the impact of monetary impulses 
especially on the financial markets under a sufficient degree of central bank 
credibility takes place immediately. Sometimes the financial market response 
even precedes the actual central bank intervention, as market participants antici-
pate the envisaged measures and act accordingly in advance.
 The last decades have witnessed major transformations pertaining to both 
monetary policy theory and practice. Since the Bretton Woods collapse central 
banks exposed not only to a higher degree of freedom, but also to the need to 
define clear monetary policy goals and communicate them to the public. In the 
last two decades, a growing number of central banks (such as the Bank of Eng-
land, Bank of Canada, the Reserve Bank of New Zealand and the Swedish Riks-
bank) have opted for systematic policy behaviour by means of introducing infla-
tion-targeting. On the theoretical side, major advances have been made in the 
last two decades. One facet of the new consensus on monetary policy is that low, 
stable inflation is crucial for market-driven growth and that the monetary policy 
stance in the medium to long run is the major determinant of inflation. After a 
long period of focusing on the impact of non-monetary factors on the business 
cycle, empirical studies since the late 1980s have argued that monetary policy 
significantly influences the short-term course of the economy. Another facet is 
the strengthened focus on monetary policy design and the interest for optimal 
rule-based monetary policy in particular. Recent macroeconomic research fea-
tures nominal rigidities and output fluctuations and focuses on the stabilization 
role of monetary policy, by allowing the monetary authorities to choose from a 

variety of monetary policy rule specifications in terms of policy instruments, 
target variables and size of the response coefficients assigned to the target vari-
ables.  Since the results obtained in the literature when assessing the different 
monetary policy rule specifications are to a large extent model-dependent, the 
choice of a macroeconomic framework based on sufficiently realistic assump-
tions is crucial for the analysis of the implications of different rule 
specifications. 
Building on the arguments of the New Classical Critique in the 1970s, New 
Keynesian models that incorporate rational expectations, as well as microeco-
nomic foundations, have been developed. The optimizing behaviour on the part 
of households and firms, as well as the intertemporal methodology of New 
Keynesian models with nominal rigidities enable detailed study of the monetary 
transmission mechanism and optimal monetary policy design. However, with 
respect to investment and capital, most of these models (e.g. Woodford (1995), 
Rotemberg and Woodford (1999) and McCallum and Nelson (1999b)) abstract 
from investment (constant-capital specification). One reason is that introducing 
endogenous capital and investment to a model with sticky prices may lead to 
multiple rational-expectations equilibria under certain monetary policy rule 
specifications. Moreover, the exclusion of capital is often justified on the 
grounds that capital does not exhibit substantial volatility at business cycle fre-
quencies (e.g. McCallum and Nelson, 1997). However, such an approach is 
clearly unsatisfactory, as it leaves out an important monetary transmission chan-
nel and shock propagation mechanism.  
In the following chapters, the analysis is carried out within a New Keynes-
ian framework with endogenous capital, sticky prices and wages and capital ad-
justment costs. The purpose of this study is to assess different interest rate rule 
specifications with respect to the degree of activeness (measured by the inflation 
response coefficient) and the target variables included, based on two criteria: (i) 
the existence of a determinate rational expectations equilibrium and (ii) the 
characteristics of the convergence path towards steady state after a shock occurs. 
In particular, policy rule specifications that yield determinacy of rational expec-
tations equilibrium and in addition involve quantitatively smaller deviations and 
fast, monotonic convergence after a shock occurs would be preferred. The re-
sults obtained confirm that the introduction of endogenous capital and invest-
ment has important implications for the monetary policy outcomes. A stronger 
than one-on-one nominal interest rate response to inflation in the policy rule (i.e. 

Interest-Rate Rules in a New Keynesian Framework with Investment by Elena Pavlova