Investment and Interest Rate Policy in the Open Economy

Investment and Interest Rate Policy in the Open

Economy

Stephen McKnight*

University of Reading

October 2007^t

Abstract

This paper presents a two-country sticky-price model that allows for capital and
investment spending. It analyzes the conditions for equilibrium determinacy un-
der alternative interest-rate rules that react to either domestic or consumer price
inflation. It is shown that in the presence of investment, real indeterminacy is con-
siderably easier to obtain once trade openness is permitted. Consequently we argue
that sufficiently open economies should adopt a backward-looking rule and suffi-
ciently closed economies should employ a current-looking rule, in order to minimize
policy induced aggregate instability.

JEL Classification Number: E32; E43; E53; E58; F41

Keywords: Real indeterminacy; Open economy macroeconomics; Interest rate rules;

Monetary Policy.

* Correspondence address: Stephen McKnight, Department of Economics, University of Reading,
Whiteknights, PO Box 219, Reading, RG6 6AW, UK. E-mail: [email protected].

tI would like to thank Roy Bailey, Ken Burdett, Joao Miguel Ejarque, Aditya Goenka, Mark Guzman,
Kerry Patterson and Helmut Rainer. Financial assistance was gratefully provided by the Economic and
Social Research Council (ESRC). As always, the usual disclaimer applies.

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