Description

New Keynesian Model This section, we develop a dynamic stochastic general equilibrium model with monopolistic competition and nominal price rigidities, which can form the basis for a simple linear macroeconomic model that is useful for policy analysis. We combine a stochastic MIU model with the assumption of monopolistically competitive goods markets and Calvo-style price stickiness. In this model, nominal wages will be allowed to fluctuate freely. The model is a consistent general equilibrium model in which all agents face well-defined decision problems and behave optimally. This modification yields a framework, often referred to as New Keynesian, that is directly linked to the more traditional aggregate supply-demand (AS-IS-LM) model that long served as one of the workhorses for monetary policy analysis. 

1 The New Keynesian Model: 

Main Elements and Features In the 1970s, 1980s, and early 1990s, the standard models used for most monetary policy analysis combined the assumption of nominal rigidity with a simple structure linking the quantity of money to aggregate spending. This linkage was usually directly through a quantity theory equation in which nominal demand was equal to the nominal money supply, often with a random disturbance included, or through a traditional textbook IS-LM model. While the theoretical foundations of these models were weak, the approach proved remarkably useful in addressing a wide range of monetary policy topics. More recently, attention has been placed on ensuring that the model structure is consistent with the underlying behavior of optimizing economic agents. The standard approach today builds on a dynamic, stochastic, general equilibrium framework based on optimizing behavior, combined with some form of nominal wage and/or price rigidity. This modification yields a framework, often referred to as New Keynesian. Early examples of models with these properties include those of Yun (1996), Goodfriend and King (1997), Rotemberg and Woodford (1995, 1997), and McCallum and Nelson (1999). The new Keynesian monetary model inherited its core from the RBC model and its dynamic stochastic general equilibrium (DSGE) structure. These are the assumption of (i) an infinitelylived representative household, who seeks to maximize the utility from consumption and leisure, subject to an intertemporal budget constraint, and (ii) a large number of firms with access to an identical technology, subject to exogenous random shocks. Also, as in RBC theory, an equilibrium takes the form of a stochastic process for all the economy’s endogenous variables, that come from optimal intertemporal decisions by households and firms, given their objectives and constraints, and with the clearing of all markets.