Monetary Policy in Models with Capital

Abstract

This chapter discusses monetary policy in models with capital. The introduction of optimizing government initially seemed to offer the possibility of similar scientific benefits. The nature of monetary policy with or without commitment, including the possibility of commitment arising endogenously, basically two types of models has been used in the literature. For the evaluation of policies, including both the optimal and the time-consistent ones, it is necessary to be able to determine the competitive equilibrium, given a policy rule that generally is a function of the aggregate state of the economy. Kehoe (1987) showed in a public-finance model with utility-maximizing consumers and benevolent governments that, without commitment versus private agents, the cooperative solution may be inferior for reasons similar to those explaining why the time-consistent solution can be very suboptimal within a given country. In contrast with this type of model of monetary policy-making, models of fiscal policy have been much more explicit in their specification of what decisions people make and what problems they solve. Incentives for capital accumulation are at the heart of time inconsistency. In particular, while most people may accept that view in the context of fiscal policy, it is less common in discussions of monetary policy.