Conclusion
In this chapter, we have analyzed the structure and the properties of a new Keynesian model based on monopolistic competition and staggered pricing. Unlike traditional Keynesian models, in which the basic relations are not derived explicitly from microeconomic foundations, this new Keynesian model is a DSGE model based on explicit microeconomic foundations, analogous to those of new classical models.
After presenting the properties of this model, we analyzed the effects of monetary and real shocks with regard to fluctuations in excess output and inflation. This new Keynesian model can explain aggregate fluctuations caused by monetary shocks. These shocks are transmitted to real variables and persist over time through staggered pricing. Such monetary cycles cannot result from models with immediate and full adjustment of wages and prices, unless there is imperfect information, as in the Lucas [1972] misperceptions model.
As in the fully competitive new classical models, when there is full flexibility of prices and wages, monetary shocks affect only nominal and not real variables, such as output, consumption, employment, real wages, and real interest rates. The assumption of monopolistic competition does not affect the issue of the neutrality of money.
Note that there is no unemployment in this model. Output deviates from its natural rate because of staggered pricing, but fluctuations in employment are due to intertemporal substitution in labor supply, because the labor market is assumed fully competitive. This is a significant weakness of this particular model, a weakness shared with the Lucas [1972] new classical model. An additional weakness of the model is that there is no trade-off between the stabilization of inflation and the stabilization of output and employment. One leads to the other, as if by a divine coincidence.
These weaknesses can be addressed if one allowed for labor market distortions that can account for unemployment.
In the next chapter, we examine a model with labor market distortions that can account for both involuntary unemployment, the real effects of nominal shocks, and a trade-off between the stabilization of inflation, output, and employment.1. This model of monopolistic competition, with a constant elasticity of demand, is due to Dixit and Stiglitz [1977].
2. See Akerlof and Yellen [1985], Mankiw [1985], Blanchard and Kiyotaki [1987], and Ball and Romer [1990] for the first generation of new Keynesian models that relied on monopolistic competition.
3. An observationally equivalent model, the Rotemberg [1982a,b] model of quadratic costs of adjusting prices, is briefly analyzed in section 16.3 of this chapter. The concept of staggered price and wage adjustment was first introduced to macroeconomics by Akerlof [1969]. Versions of staggered nominal wage contracts were used to study the role of monetary policy under rational expectations by Fischer [1977a] and Taylor [1979, 1980]. These contracts were fixed-term contracts. Calvo [1983] generalized the Taylor fixed-term contracts to contracts with a stochastic duration.
4. In most models of staggered pricing, it is assumed that the firms that are constrained cannot adjust their prices at all. Yun [1996] is probably the first analysis of a new Keynesian DSGE model, such as the one in this section, using the Calvo [1983] assumption of staggered pricing. However, in the case that one does not allow for indexation to the steady state inflation rate, and steady state inflation is positive, the model violates the natural rate property. Increasing steady state inflation would affect steady state output and employment. See, for example, Ascari and Sbordone [2014].
5. In view of the emergence of a new neoclassical synthesis around DSGE models, highlighted by Goodfriend and King [1997], (16.43) is often labeled as the new neoclassical synthesis IS curve, as it characterizes both new classical and new Keynesian models.
6. Starting with Erceg et al. [2000], various papers in the new Keynesian tradition have analyzed this model with the additional assumption of staggering of nominal wages. In this case, there are additional fluctuations in output and employment, because wages do not equate the demand with the supply of labor in each period, as is assumed here. See, for example, Gali [2008, 2011b].
7. In the Taylor rule (16.48), the nominal interest rate does to react to shocks that cause fluctuations in the natural real rate of interest, such as productivity shocks. The rule is only conditioned on the steady state real interest rate ρ and core inflation (i.e., the steady state inflation target of the central bank π*). Thus, productivity shocks turn out to affect deviations of output from its own natural rate and deviations of inflation from the central bank’s target. Obviously, one can also analyze the imperfectly competitive new Keynesian model under the assumption that monetary policy follows a rule for the money supply and not nominal interest rates. See Gali [2008].
8. See chapters 12 and 14 for discussions of the properties of interest rate rules. Clarida et al. [1999], Woodford [2003a] and Gali [2008] contain extensive discussions of interest rate rules in new Keynesian models. We shall discuss the properties of the Taylor [1993] rule more fully in chapter 20, on the role of monetary policy.
9. The assumption of AR(1) processes for the exogenous disturbances is again made for analytical simplicity and could easily be generalized.
10. See chapter 9 for solution methods of dynamic models with rational expectations.
11. In fact, the model of Erceg et al. [2000] is not characterized by the divine coincidence, as there is additional staggering for nominal wages. We return to this issue in chapter 17, where we present a model of unemployment and nominal wage contracts that is also not characterized by the divine coincidence.