The perfectly competitive new classical models that we analyzed in chapters 13 and 14 are examples of DSGE models in which wages and prices are perfectly flexible and equilibrate both the product and labor markets.

In such models, only real shocks (such as shocks to productivity) can affect the fluctuations of output, employment, and other real variables. Monetary shocks only affect nominal variables, such as the price level and inflation.

In this chapter, we introduce an imperfectly competitive macromodel based on staggered price setting. This is a DSGE model based on distortions in product markets. We initially analyze it assuming both full flexibility of wages and prices and, subsequently assuming staggered price adjustment. The model with full flexibility of wages and prices is comparable to the perfectly competitive new classical model presented in chapter 14. The model with staggered pricing allows for a Phillips curve–type relation between inflation and deviations of output and employment from their natural rates, and thus for real effects of nominal shocks and monetary policy. This model differs from the new classical model in that nominal shocks and monetary policy have real effects, not because of imperfect information, but because of the imperfect adjustment of nominal prices.

The imperfectly competitive model introduced in this chapter has two important differences from the typical perfectly competitive new classical DSGE model. First, instead of fully competitive markets for goods and services, it assumes that markets are characterized by conditions of monopolistic competition. Firms have market power and do not take prices as given, but determine prices themselves so as to maximize profits. Because of the market power of firms and the existence of monopolistic competition, the natural rate of employment, real output, consumption, and real wages are determined at lower levels than in the corresponding perfectly competitive model.

Second, this imperfectly competitive model can account for a Phillips curve type of relation, assuming that firms adjust prices only gradually. Two observationally equivalent versions of gradual price adjustment have dominated the literature since the early 1980s. One is the Rotemberg [1982a, 1982b] model of costly price adjustment, and the second is the Calvo [1983] model of staggered pricing. In the Rotemberg model, firms face convex costs of adjusting prices, which they balance against convex costs of deviating from the profit-maximizing optimal steady state price. They end up gradually adjusting prices toward the profit-maximizing steady state price. In the Calvo model, it is assumed that only a fixed proportion of firms have the freedom to adjust prices in any given period, with the remaining firms not being able to do so. Although optimal pricing by firms takes this restriction into account in advance, the aggregate price level can only adjust gradually to aggregate shocks, because not all firms have the option of adjusting prices to new information in every period.

These two alternative assumptions lead to models with price stickiness, whose properties differ from full-information new classical models. They share some properties of Keynesian models of the Phillips curve and the Lucas [1972] island model. Because they are based on sluggish price adjustment, a key assumption of the original Keynesian models, such models are called new Keynesian models.

In the case of staggered pricing, it turns out that deviations of output from its natural level cause deviations of inflation from expected future inflation, as higher aggregate demand and output causes an increase in nominal marginal costs and hence prices. This results in a Phillips curve–type relation called the new Keynesian Phillips curve.

The imperfectly competitive model analyzed in this chapter has the following structure:

• Deviations of inflation from the target of the central bank are determined by the new Keynesian Phillips curve and depend on expected future deviations of inflation from the central bank inflation target, and deviations of real aggregate demand and output from its natural rate. These deviations of output from its natural rate cause a rise in inflation, as they are associated with an increase in nominal marginal costs and hence optimal prices.

• On the demand side, deviations of aggregate demand from the natural rate of real output depend on the new Keynesian IS curve and are driven by deviations of the current real interest rate from its natural rate.

• The nominal interest rate is assumed to be determined by the central bank, which follows a Taylor [1993] interest rate rule. According to the Taylor rule, which is a generalization of the Wicksell rule that we discussed in chapters 12 and 14, the nominal interest rate reacts positively to deviations of current inflation from the inflation target of the central bank, as well as deviations of real output from its natural rate. This is a countercyclical monetary policy rule, aiming to nudge inflation and output toward their equilibrium levels.

After discussing the properties of this model, we analyze the effects of monetary and real shocks on fluctuations in real output and inflation.

The imperfectly competitive new Keynesian model with staggered prices can, unlike the full information new classical model, explain monetary cycles (i.e., aggregate fluctuations caused by monetary shocks). These shocks are transmitted to real variables, and to the extent that they persist over time, they have persistent real effects.

This model is widely considered to be the benchmark new Keynesian model. However, its weakness is that it cannot account for involuntary unemployment but only for underemployment. In this particular model, because of the assumed flexibility of nominal wages, the labor market clears continuously, in the sense that labor demand is always equal to labor supply. Because of imperfect competition, the equilibrium real wage is lower than in a fully competitive model, and thus, equilibrium employment is lower than in a fully competitive economy. However, there is no involuntary unemployment, and fluctuations in employment are due to intertemporal substitution in labor supply, as in the Lucas [1972] misperceptions model.

Furthermore, this model is characterized by the so-called divine coincidence: The stabilization of inflation leads to the stabilization of output and employment around their natural rates as well. There is no trade-off between the stabilization of inflation and employment in this model. Hence, the optimal prescription for monetary policy is to fully stabilize inflation, much like in new classical models.

Thus, the analysis of this new Keynesian model based on staggered pricing eventually leads us to conclude that to account for unemployment, one has to investigate models with distortions in the labor market. We take up this topic in chapter 17.

16.1