Abstract :
Empirical studies show that when the interest rate is included, money loses its predictive power on output. This paper explains this finding by using a rational expectations model where production decisions of firms require debt financed working capital. The cost of working capital, the interest rate, affects the supply side. Monetary shocks affect the interest rate and, thus, affect the price and output produced by firms. The model shows that this can cause the predictive power of monetary shocks on output to diminish when the interest rate is used in empirical analysis. The model also alludes to the effects of monetary policy on the price level through the supply side (cost push) factors.
