Increasing Returns and the Design of Interest Rate Rules

Abstract

We introduce increasing returns to scale into an otherwise standard New Keynesian model with capital, and study the determinacy and E-stability of Taylor-type interest rate rules. With very mild increasing returns supported by empirical research, the conventional wisdom regarding the design of interest rate rules can be overturned. In particular, the "Taylor principle" no longer guarantees either determinacy or E-stability of the rational expectations equilibrium.

Investment, interest rate policy, and equilibrium stability

“…A similar result is obtained byXiao (2007), who uses a discrete time model with an increasing returns to scale production technology.2 Sveen and Weinke (2005) find that the active current-looking policy is more likely to induce indeterminacy as prices become stickier. Under the current-looking policy, determinacy depends on the effects of a cost channel of monetary policy relative to an aggregate demand channel, as mentioned later Benhabib and Eusepi (2005).…”

“…8 Xiao (2007) shows that in an associated model with a finite labor supply elasticity and a capital adjustment cost, a mild policy response to expected future output can ameliorate the indeterminacy problem. 9 This cost channel is similar to that in the existing literature such as Christiano and Eichenbaum (1992) and Barth and Ramey (2001) in that a rise in the interest rate increases firms' marginal cost.…”

“…A few recent studies incorporate some of these features into our fundamental model to investigate equilibrium determinacy numerically. Xiao (2007) uses such a model incorporating a finite labor supply elasticity and a capital adjustment cost and then shows that a mild policy response to expected future output helps the forward-looking policy ensure determinacy. Huang and Meng (2007b) employ a similar model to Xiao to find that under an empirically reasonable labor supply elasticity, the policy response to current output fails to make the forward-looking policy generate determinacy, but once staggered nominal wage setting is incorporated into their model, the role of such a policy response in guaranteeing determinacy is greatly enhanced.…”

Macroeconomic (in)stability and endogenous market structure with productive government expenditure

“…Hornstein (1993),Devereux, Head, and Lapham (1996),Xiao (2008) andBrito and Dixon (2013) provide a similar specification in the intermediate goods production, while their analysis downplays the role of the public good externality, i.e. χ = 0.…”

Returns to Scale, Market Power, and the Nature of Price Rigidity in New Keynesian Models with Self‐Fulfilling Expectations

“…Xiao () and Huang and Meng () also use the Calvo model to analyze the implications of increasing returns to scale for macroeconomic stability under alternative interest rate policy rules, and Weder () conducts a similar analysis in a monetary model with flexible prices. In a monetary model with a constant returns to scale technology and labor as the only productive input, Weder () shows how the Calvo price setting may reduce the scope of indeterminate equilibria under a constant money supply rule.…”