Smoothing the New-Keynesian Capital Puzzle

Eduardo Amaral

No 606, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: Rupert and Šustek (2019) showed that introducing endogenous capital into the canonical New-Keynesian model allows real interest rates to move in any direction after a positive monetary shock. According to them, this would prove that the real interest rate channel of monetary policy transmission is only observational — not structural — in that class of models, and therefore subject to the Lucas (1976) critique. In this paper, I show that such an identification problem for dynamic stochastic general equilibrium (DSGE) and vector autoregression (VAR) models can be circumvented by incorporating interest-rate smoothing — a feature as prevalent in medium-scale New-Keynesian models as capital itself — into the Taylor rule. I find that the negative association between changes in inflation and changes in the real interest rate is actually more robust than that between the former and changes in the nominal interest rate.

Date: 2024-11
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mon
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