An Optimizing IS-LM Framework with Endogenous Investment

Dynamic optimizing models with an IS-LM-type structure and slow price adjustments have been used for much recent monetary policy analysis, but usually with capital and investment treated as exogenous—a significant restriction. This paper demonstrates that investment decisions can be endogenized without undue complexity in such models and that these can be calibrated to provide reasonably realistic dynamic behavior. It is necessary, however, to include capital adjustment costs; models with no adjustment costs match cyclical data very poorly. Indeed, their match is considerably poorer than models with constant capital. The paper also finds that the preferred adjustment-cost specification is not close to quadratic.