1 Introduction
There is a large body of research that has considered the real indeterminacy implications
of designing interest-rate rules in sticky-price monetary models.1 The general conclusion
that emerges from the literature is that in order to rule out real indeterminacy the mon-
etary authority should follow the Taylor principle (i.e. an active policy stance), that is,
a policy that aggressively targets either expected inflation (e.g. Bernanke and Wood-
ford (1997), Clarida et al. (2000)) or current inflation (e.g. Kerr and King (1996)) by
raising the nominal interest rate by proportionally more than the increase in inflation.
However a number of recent studies have challenged the appropriateness of the Taylor
principle in preventing multiplicity of equilibrium once the economic environment allows
for capital and investment spending. Dupor (2001) introduces investment spending using
a continuous- time framework and shows that a passive policy stance is required for equi-
librium determinacy. In a discrete-time framework, Carlstrom and Fuerst (2005) show
that with the addition of capital and investment spending equilibrium “determinacy is
essentially impossible” under a forward-looking interest-rate rule.2 For current-looking
interest-rate rules, Carlstom and Fuerst (2005), Sveen and Weinke (2005) and Benhabib
and Eusepi (2005) all find that the Taylor principle is not a sufficient condition for deter-
minacy, although the range of indeterminacy generated is typically small.3
The purpose of this paper is to investigate the importance of investment spending
for equilibrium determinacy for economies that are open to international trade in goods
and assets. Using a discrete-time, money-in-the-utility function framework, this paper
develops a two-country, sticky-price model that allows for capital and investment spend-
ing.4 The conditions for real equilibrium determinacy are analyzed for forward, current
and backward-looking versions of the interest rate rule. In addition, two alternative price
1 By real indeterminacy we simply mean that there exists a continuum of equilibrium paths, starting from
the same initial conditions, which converge to the steady state.
2 Interestingly, Kurozumi and Van Zandweghe (2007) show that the range of determinacy can be signif-
icantly increased if the monetary authority implements an interest rate policy that responds to both
expected inflation and current output.
3 Sveen and Weinke (2005) show that the range of indeterminacy is higher if firm-specific capital is assumed,
relative to the more common assumption of a competitive rental market for capital. Benhabib and Eusepi
(2005) show that the range of parameter values that guarantee local determinacy do not necessarily
guarantee global determinacy.
4 To facilitate comparison with the existing literature, this paper adopts the traditional convention that
end-of-period money balances enter the utility function. Assuming an alternative timing-assumption
would have important consequences for equilibrium determinacy, as discussed by Carlstrom and Fuerst
(2001), Kurozumi (2006) and McKnight (2007).