Copyright @ 2011 Central Bank Review. This article is available open access through the publisher’s website at the link below.We show that a standard DSGE model with investment cost channels has
important model stability and policy implications. Our analysis suggests that in
economies characterized by supply side well as demand side channels of monetary
transmission, policymakers may have to resort to a much more aggressive stand against
inflation to obtain locally unique equilibrium. In such an environment targeting output
gap may cause model instability. We also show that it is difficult to distinguish
between the New Keynesian model and labor cost channel only case, while with
investment cost channel differences are more significant. This result is important as it
suggests that if one does not take into account the investment cost channel, one is
underestimating the importance of supply side effects
