An optimizing IS-LM framework with endogenous investment

Abstract

Dynamic optimizing models with an IS-LM-type structure and slow price adjustments have been used for much recent monetary policy analysis, but usually with capital and investment treated as exogenous-a significant restriction. This paper demonstrates that investment decisions can be endogenized without undue complexity in such models and that these can be calibrated to provide reasonably realistic dynamic behavior. It is necessary, however, to include capital adjustment costs; models with no adjustment costs match cyclical data very poorly. Indeed, their match is considerably poorer than models with constant capital. The paper also fmds that the preferred adjustment-cost specification is not close to quadratic.

Interest-Rate Rules in a New Keynesian Framework with Investment

“…The above deficiencies notwithstanding, models with endogenous capital and convex capital adjustment costs still perform better than the ones with endogenous capital only. This is confirmed by Casares and McCallum (2006) who argue that models with endogenous capital/investment choices but no adjustment costs imply highly unrealistic responses to monetary-policy shocks under the assumption of sticky prices and wages.…”

“…Woodford (2003) provides a further critique on models with constant capital: "while this has kept our analysis of the effects of interest rates on aggregate demand quite simple, one may doubt the accuracy of the conclusions obtained, given the obvious importance of variations in investment spending both in business fluctuations and in the transmission mechanism for monetary policy in particular." Casares and McCallum (2006) provide a further argument for the inclusion of endogenous capital and investment, as it enables not only studying issues relating to capital formation and growth, but also provides an endogenous explanation for the empirically observed contrasting variability of consumption and investment spending.…”

“…Recent models, such as Casares and McCallum (2006), McCallum and Nelson (1999b) and Rotemberg and Woodford (1998a) all include an interest rate instrument, whereby the money supply is endogenous since the central bank must vary it in order to sustain its desired interest rate level. In these models the path for money growth followed by the monetary authority in the long run under an interest rate instrument exactly coincides with the one that would be followed under a money supply instrument.…”

“…As already mentioned in Section 1, three possible assumptions about investment and the capital stock could generate an inertial response on part of capital: capital accumulation adjustment costs, a time-to-build requirement and firm-specific capital. As shown by Casares and McCallum (2006), an appropriate possibility to endogenise investment in a less complex manner is to incorporate endogenous investment with capital adjustment costs under sluggish price adjustment in a dynamic model of the IS-LM type with optimising behaviour 78 . This is approach chosen in the next section for deriving the New Keynesian model that is later used for examining the determinacy and shock response properties of different 77 My results obtained under such a specification without adjustment costs (not included here) confirm the intuition that variable responses to shocks in such a case are unrealistically large.…”

“…As already discussed in Section 1, some plausible ways of achieving this would include adopting the assumption that capital investment (or capital good "installation") creates certain costs or adding exogenous "time to build" constraints. Here I choose to endogenise the sluggishness of capital stock adjustments and adopt the adjustmentcost specification as in Hayashi (1982) and Casares and McCallum (2006). Gross investment is given by:…”