Optimal Monetary Policy with Endogenous Capital Accumulation

The previous literature on optimal monetary policy has focused mainly on dynamic stochastic general equilibrium models with a constant aggregate capital stock (cf. Woodford 1999; Erceg et al. 2000). In this paper, we analyze the monetary policy implications of endogenous capital accumulation. We augment the benchmark New Keynesian model to incorporate investment with quadratic adjustment costs, and use a perturbation algorithm to obtain the second-order approximation of the model around its steady state. Using these methods, we characterize the properties of the fully-optimal Ramsey policy under commitment, and compare the welfare implications of simple Taylor-style rules involving the inflation rate and the output gap. Simple rules in this class can be formulated in terms of two alternative definitions of potential output: the level that would prevail under flexible wages and prices, conditional on the current capital stock (as in Woodford 2003), or the level corresponding to a frictionless economy in which wages and prices had always been flexible (as in Nelson and Neiss 2003). Our analysis documents the relative performance of simple rules involving these definitions, and then considers the extent to which our findings are robust to various extensions of the baseline model, including variable capacity utilization, limited reallocation of capital across firms, and higher-order adjustment costs (as in Christiano, Eichenbaum and Evans 2001)