Paper #780

Title:

Firm-specific investment, sticky prices and the Taylor principle

Authors:

Tommy Sveen and Lutz Weinke

Date:

October 2004

Abstract:

According to the Taylor principle a central bank should adjust the nominal interest rate by more than one-for-one in response to changes in current inflation. Most of the existing literature supports the view that by following this simple recommendation a central bank can avoid being a source of unnecessary fluctuations in economic activity. The present paper shows that this conclusion is not robust with respect to the modelling of capital accumulation. We use our insights to discuss the desirability of alternative interest rate rules. Our results suggest a reinterpretation of monetary policy under Volcker and Greenspan: The empirically plausible characterization of monetary policy can explain the stabilization of macroeconomic outcomes observed in the early eighties for the US economy. The Taylor principle in itself cannot.

Keywords:

Sticky prices, aggregate investment, monetary policy

JEL codes:

E22, E31

Area of Research:

Macroeconomics and International Economics

Published in:

Journal of Economic Theory Vol. 123, No. 1, pp 21-39, July 2005

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