Introduction

We consider a small, open economy inhabited by an optimising corporate sector and a large number of optimising individuals who each period must formulate, amongst other things, dynamic programmes for investment and consumption following stochastic shifts in total factor productivity. We then ask three questions: What would the marginal productivity of capital, or real interest rate, look like over the course of the cycle in such an economy? How closely does the observed real interest rate in a small, open economy (the United Kingdom) resemble this hypothetical rate? And can we describe ‘inflation and output determination as depending on the relation between a ‘natural rate of interest’ determined primarily by real factors and the central bank's rule for interest rates’ (Woodford, 2000a, p. 2)?

We are accustomed to the supply side of an economy, as measured by the long-run average rate of productivity growth, being the most natural explanation for long-run real outcomes in growth and welfare (Griliches, 1996). But, as economists have recognised that the productivity cycle might be closely related to the propagation or impulses of the business cycle, the cyclical behaviour of productivity has increasingly attracted their attention (Cooley, 1995). Beginning with the seminal papers of Long and Plosser (1983) and Kydland and Prescott (1982), an important strand of macroeconomic research has attempted to construct small, theoretically coherent models based on optimising agents that capture key cyclical patterns in the actual data.