Should Central Banks Care about Investment?

Abstract

We ask how including endogenous capital formation into a New-Keynesian model affects optimal monetary policy. We find that the response of Ramsey optimal policy to a persistent cost-pushing shock is unconventional: In response to the shock, the central bank persistently reduces the nominal interest rate below its steady state. We find that this is due to a decrease in the natural interest rate and does not reflect a desire to choose a systematically different point on the policy frontier. However, the central bank’s tradeoff is affected in the sense that inflation stabilization can become more costly: When analyzing optimal simple rules, we find that these can imply welfare losses which substantially exceed those of Ramsey optimal policy. The reason is that active interest rate policy magnifies output fluctuations by destabilizing the capital stock. When introducing adjustment cost, our results return to standard: First, Ramsey optimal policy increases the interest rate as a response to a cost-pushing shock. Second, active policy becomes more successful in mimicking the allocation a Ramsey planner would choose.