wp03-20 - working p a p e r 03 20 Investment and Interest...

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working paper FEDERAL RESERVE BANK OF CLEVELAND 03 20 Investment and Interest Rate Policy: A Discrete Time Analysis by Charles T. Carlstrom and Timothy S. Fuerst
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Working papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views stated herein are those of the authors and are not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Working papers are now available electronically through the Cleveland Fed’s site on the World Wide Web: www.clevelandfed.org/research.
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Working Paper 03-20 December 2003 Investment and Interest Rate Policy: A Discrete Time Analysis by Charles T. Carlstrom and Timothy S. Fuerst This paper analyzes the restrictions necessary to ensure that the interest rate policy rule used by the central bank does not introduce local real indeterminacy into the economy. It conducts the analysis in a Calvo-style sticky price model. A key innovation is to add investment spending to the analysis. In this environment, local real indeterminacy is much more likely. In particular, all forward-looking interest rate rules are subject to real indeterminacy. JEL Classification: E4, E5 Key Words: interest rates, monetary policy, central banking Charles T. Carlstrom is at the Federal ReserveBank of Cleveland and may be reached at [email protected] or (216) 579-2294, Fax: (216) 579-3050. Timothy S. Fuerst is at Bowling Green State University and may be reached at [email protected] Or (419) 372-6868; Fax: (419) 372-1557.
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I. Introduction. The celebrated Taylor (1993) rule posits that the central bank uses a fairly simple rule when conducting monetary policy. This rule is a reaction function linking movements in the nominal interest rate to movements in inflation and possibly other endogenous variables. A rule is called active if the elasticity with respect to inflation (denoted by τ ) is greater than one; the rule is called passive if τ is less than one. Recently there has been a considerable amount of interest in ensuring that such rules do no harm. The problem is that by following a rule in which the central bank responds to endogenous variables, the central bank may introduce real indeterminacy and sunspot equilibria into an otherwise determinate economy. These sunspot fluctuations are welfare-reducing and can potentially be quite large. A standard result is that to avoid real indeterminacy the central bank should respond aggressively ( τ > 1) to either expected inflation (see Bernanke and Woodford (1997) and Clarida, Gali, Gertler (2000)) or current inflation (see Kerr and King (1996)).
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This note was uploaded on 02/29/2012 for the course ECON 4020 taught by Professor Ellen during the Spring '12 term at Bowling Green.

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wp03-20 - working p a p e r 03 20 Investment and Interest...

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