New Keynesian Model Research Articles

Can the Learnability Criterion Ensure Determinacy in New Keynesian Models?

Forward-looking rational expectation (RE) models such as the popular New Keynesian (NK) model do not provide a unique prediction about how the model economy behaves. We need some mechanism that ensures determinacy. McCallum (2012) says it is not needed because models are learnable only with the determinate solution and so the NK model, once learnt in this way, will be determinate. We agree the only learnable solution that has agents converge on the true NK model is the bubble-free one. But once they have converged, they must then understand the model and its full solution therefore including the bubble. Hence, the learnability criterion still fails to pick a unique RE solution in NK models. JEL Classifications: C62, D84

The effects of oil price shocks in a new-Keynesian framework with capital accumulation

The economic implications of oil price shocks have been extensively studied since the 1970s. Despite this huge literature, no dynamic stochastic general equilibrium model was available that captures two well-known stylized facts: (1) the stagflationary impact of an oil price shock, together with (2) the influence of the energy efficiency of capital on the depth and length of this impact. We build, estimate and simulate a New-Keynesian model with capital accumulation, which takes the case of an economy where oil is imported from abroad, and where these stylized facts can be accounted for. Moreover, the Bayesian estimation of the model on the US economy (1984–2007) suggests that the output elasticity of oil might have been above 10%, stressing the role of oil use in US growth at this time. Finally, our simulations confirm that an increase in energy efficiency significantly attenuates the effects of an oil shock—a possible explanation of why the third oil shock (1999–2008) did not have the same macro-economic impact as the first two ones. These results suggest that oil consumption and energy efficiency have been two major engines for US growth in the last three decades.

Heterogeneity in Wage Setting Behavior in a New-Keynesian Model

In this paper we estimate a New-Keynesian DSGE model with heterogeneity in price and wage setting behavior. In a recent study, Coibion and Gorodnichenko (2011) develop a DSGE model, in which firms follow four different types of price setting schemes: sticky prices, sticky information, rule of thumb, or flexible prices. We enrich Coibion and Gorodnichenko (2011) framework by incorporating heterogeneity in nominal wage setting behavior among households. We solve this DSGE model and estimate it using Bayesian techniques for the United States economy for the period of 1955-2014. Our results confirm the previous findings in the literature regarding the importance of nominal rigidity in wages to better match the macroeconomic data. More importantly, we identify qualitative as well as quantitative business cycle features allowed by the heterogeneity in wage rigidity, such as the persistence in price and the wage inflation, which a standard New Keynesian model with only Calvo-type wage rigidity fails to achieve. We also show that modelling wage rigidity heterogeneity - as oppose to standard-Calvo-wages - amplifies the macroeconomic output fluctuations resulting from a technology shock whereas it mitigates the output fluctuations following a monetary tightening.

Globalization, Market Structure and the Flattening of the Phillips Curve.

The decline in the sensitivity of inflation to domestic slack observed in developed countries over the last 25 years has been often attributed to globalization. However, this intuition has so far not been formalized. I develop a general equilibrium setup that can rationalize the flattening of the Phillips curve in response to a fall in trade costs. In order to do so, I add three ingredients to an otherwise standard two-country new-Keynesian model: strategic interactions generate time varying desired markup; endogenous firm entry makes the market structure change with globalization; heterogeneous productivity allows for self-selection among firms. Because of productivity heterogeneity, only high-productivity firms (that are also the bigger ones) enter the export market. They tend to transmit less marginal cost fluctuations into inflation because they absorb them into their desired markup in order to protect their market share. At the aggregate level, the increase in the proportion of large firms reduces the pass-through of marginal cost into inflation.

Sufficient conditions for determinacy in a class of Markov-switching rational expectations models

Markov-switching rational expectations (MSRE) models can bring out fresh insights beyond what linear rational expectations models have done for macroeconomics, as noted and predicted by Davig and Leeper (2007) and Farmer et al. (2009), among others. However, a lack of tractable methodological foundations may have hindered researchers from uncovering the salient features of MSRE models. This study proposes a solution method and derives very tractable sufficient conditions for determinacy and indeterminacy in the mean-square stability sense in general MSRE models with lagged endogenous variables. These tasks are accomplished by extending the forward method of Cho and Moreno (2011) developed for linear rational expectations models to MSRE models. We apply our methodology to a New-Keynesian model subject to regime-switching in monetary policy and find some unforeseen but intuitive determinacy results.

New Keynesian Macroeconomic Model and Monetary Policy in Pakistan

The New Keynesian (NK) models have advantage over the Real Business Cycle (RBC) models as they allow rigidities in the structure of the model, hence provide built-in mechanism to incorporate the structural shocks. The estimation of the NK model for Pakistan’s economy remains a relatively unexplored area. This study attempts to estimate a closed economy version of the NK model using robust econometric technique. On the empirical side macroeconomic dynamics have been investigated in response to unanticipated monetary shock. The reaction of the monetary authority (the State Bank of Pakistan) in response to structural shocks has been assessed by exploring the role of forward looking expectations. The SVAR model has been employed to estimate the structural parameters. The response of macroeconomic aggregates to structural shocks has also been simulated along with discussing the forecast error variance decomposition. The role of forward looking expectations is found to play prominent role in the prevailing market structure of the country. The State Bank of Pakistan (SBP) has been found to respond to shocks after a lag of one or more periods indicating time inconsistency problem which is due to discretionary monetary policy stance being adopted by the monetary authority. The distorted beliefs of economic agents about the stance of monetary policy have pointed towards weak effectiveness of the monetary policy. The results suggest that the SBP would have to adopt an independent and transparent monetary policy by following some sort of Taylor-type rule. JEL Classification: C32, C51, E52, E58 Keywords: New Keynesian Models, Real Business Cycle Models, Forward Looking Expectations, SVAR Model, Price Puzzle

Monetary Policy and the Natural Rate of Interest

It is most important for monetary policy to track the natural rate of interest when interest rates take large and sustained swings away from their long‐run equilibrium values. Here, we study two models: a standard New Keynesian model and one in which government bonds provide liquidity. Policy rules that cannot track the natural rate perform poorly in both models, but are especially bad in the second because of sustained movements in the natural rate induced by fiscal shocks. First difference rules, on the other hand, do surprisingly well. When model uncertainty is taken into account, the dominance of the first difference rule is even more pronounced.

Solving and estimating indeterminate DSGE models

We propose a method for solving and estimating linear rational expectations models that exhibit indeterminacy and we provide step-by-step guidelines for implementing this method in the Matlab-based packages Dynare and Gensys. Our method redefines a subset of expectational errors as new fundamentals. This redefinition allows us to treat indeterminate models as determinate and to apply standard solution algorithms. We prove that our method is equivalent to the solution method proposed by Lubik and Schorfheide (2003, 2004), and using the New-Keynesian model described in Lubik and Schorfheide (2004), we demonstrate how to apply our theoretical results with a practical exercise.

Informational Effects of Monetary Policy

We analyse a simplified New-Keynesian model with an unobserved aggregate cost-push shock in which firms and the central bank have different information about the shock. We consider a linear policy rule where a pure inflation targeting central bank decides how much to react to the shock given its information. In this framework we show that monetary policy performs both an allocational and an informational role, the latter due to firms extracting information on the aggregate shock from the monetary policy tool. When the informational role is present, optimal monetary policy is more cautious, that is, it responds less to the shock than the perfect information benchmark. A more cautious reaction to the shock implies that firms make more effective use of their private information and the endogenous information coming from the aggregate price in order to make inferences about the shock.

Monetary Policy, Trend Inflation and the Great Moderation: An Alternative Interpretation - Comment

Working with a small-scale calibrated New-Keynesian model, Coibion and Gorodnichenko (2011) find that the reduction in trend inflation during Volcker's mandate was a key factor behind the Great Moderation. We revisit this finding with an estimated New-Keynesian model with trend inflation and no indexation based on Christiano, Eichenbaum and Evans (2005). First, our simulations confirm Coibion and Gorodnichenko's (2011) main finding. Second, we show that a trend inflation-immune Taylor rule based on economic theory can avoid indeterminacy even at high levels of trend inflation such as those observed in the 1970s.

Estimating Non-Linear DSGES with the Approximate Bayesian Computation: An Application to the Zero Lower Bound

Non-linear model estimation is generally perceived as impractical and computationally burdensome. This perception limited the diusion on non-linear models estimation. In this paper a simple set of techniques going under the name of Approximate Bayesian Computation (ABC) is proposed. ABC is a set of Bayesian techniques based on moments matching: moments are obtained simulating the model conditional on draws from the prior distribution. An accept-reject criterion is applied on the simulations and an approximate posterior distribution is obtained by the accepted draws. A series of techniques are presented (ABC-regression, ABC-MCMC, ABC-SMC). To assess their small sample performance, Montecarlo experiments are run on AR(1) processes and on a RBC model showing that ABC estimators outperform the Limited Information Method (Kim, 2002), a GMM-style estimator. In the remainder, the estimation of a new-keynesian model with a zero lower bound on the interest rate is performed. Non-gaussian moments are exploited in the estimation procedure.

Towards a New Keynesian Theory of the Price Level

Modifying the standard New-Keynesian model to replace firms' full information and sticky prices with flexible prices and dispersed information, and imposing mild and plausible restrictions on the monetary authority's decision rule, produces the striking results that (i) there exists a unique and globally stable steady-state rate of inflation, despite the possibility of a lower bound on nominal interest rates; and (ii) in the vicinity of steady-state, the price level is determinate (and not just the rate of inflation), despite the central bank targeting inflation. The specification of firms' signal extraction problem under dispersed information removes the need to make use of Blanchard-Kahn conditions to solve the model,thereby removing the need to adhere to the Taylor principle and consequently circumventing the critique of Cochrane (2011). The model admits a determinate, stable solution with no role for sunspot shocks when the monetary authority responds by less than one-for-one to changes in expected inflation,including under an interest rate peg. An extension to include incomplete information on the part of the central bank permits the consideration of (rational) errors of judgement on the part of policymakers and provides a theoretical basis for inertial policymaking without interest rate smoothing, in support of Rudebusch (2002, 2006.

Globalization, Market Structure and the Flattening of the Phillips Curve

The decline in the sensitivity of inflation to domestic slack observed in developed countries over the last 25 years has been often attributed to globalization. However, this intuition has so far not been formalized. I develop a general equilibrium setup that can rationalize the flattening of the Phillips curve in response to a fall in trade costs. In order to do so, I add three ingredients to an otherwise standard two-country new-Keynesian model: strategic interactions generate time varying desired markup; endogenous firm entry makes the market structure change with globalization; heterogeneous productivity allows for self-selection among firms. Because of productivity heterogeneity, only high-productivity firms (that are also the bigger ones) enter the export market. They tend to transmit less marginal cost fluctuations into inflation because they absorb them into their desired markup in order to protect their market share. At the aggregate level, the increase in the proportion of large firms reduces the pass-through of marginal cost into inflation.

Systemic Risk: A New Trade-off for Monetary Policy?

We introduce time-varying systemic risk in an otherwise standard New-Keynesian model to study whether a simple leaning-against-the-wind policy can reduce systemic risk and improve welfare. We find that an unexpected increase in policy rates reduces output, inflation, and asset prices without fundamentally mitigating financial risks. We also find that while a systematic monetary policy reaction can improve welfare, it is too simplistic: (1) it is highly sensitive to parameters of the model and (2) is detrimental in the presence of falling asset prices. Macroprudential policy, similar to a countercyclical capital requirement, is more robust and leads to higher welfare gains.

Learning from Learners

Traditional macroeconomic learning algorithms are misspecified when all agents are learning simultaneously. In this paper, we produce a number of learning algorithms that do not share this failing, and show that this enables them to learn almost any solution, for any parameters, implying learning cannot be used for equilibrium selection. As a by-product, we are able to show that when all agents are learning by traditional methods, all deep structural parameters of standard new-Keynesian models are identified, overturning a key result of Cochrane (2009; 2011). This holds irrespective of whether the central bank is following the Taylor principle, irrespective of whether the implied path is or is not explosive, and irrespective of whether agents’ beliefs converge. If shocks are observed then this result is trivial, so following Cochrane (2009) our analysis is carried out in the more plausible case in which agents do not observe shocks.

Monetary policy with interest on reserves

I analyze monetary policy with interest on reserves and a large balance sheet. I show that conventional theories do not determine inflation in this regime, so I base the analysis on the fiscal theory of the price level. I find that monetary policy can peg the nominal rate, and determine expected inflation. With sticky prices, monetary policy can also affect real interest rates and output, though higher interest rates raise output and then inflation. The conventional sign requires a coordinated fiscal–monetary policy contraction. I show how conventional new-Keynesian models also imply strong monetary–fiscal policy coordination to obtain the usual signs. I address theoretical controversies. A concluding section places our current regime in a broader historical context, and opines on how optimal fiscal and monetary policy will evolve in the new regime.

Monetary Policy with Interest on Reserves

I analyze monetary policy with interest on reserves and a large balance sheet. I show that conventional theories do not determine inflation in this regime, so I base the analysis on the fiscal theory of the price level. I find that monetary policy can peg the nominal rate, and determine expected inflation. With sticky prices, monetary policy can also affect real interest rates and output, though higher interest rates raise output and then inflation. The conventional sign requires a coordinated fiscal-monetary policy contraction. I show how conventional new-Keynesian models also imply strong monetary-fiscal policy coordination to obtain the usual signs. I address theoretical controversies. A concluding section places our current regime in a broader historical context, and opines on how optimal fiscal and monetary policy will evolve in the new regime.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Overtime Labor, Employment Frictions, and the New Keynesian Phillips Curve

Abstract This paper presents a New Keynesian (NK) model that is extended to differentiate between straight time and overtime work. The model proposes that the New Keynesian Phillips curve (NKPC) should be estimated with marginal cost measured in terms of overtime labor; the resulting coefficient estimates are in accordance with theory and statistically significant for the hybrid NKPC (which allows for backward-looking price setters) but not for the purely forward-looking NKPC. In the hybrid model, backward-looking behavior is found to be predominant. The paper also shows that the incorporation of employment frictions (predetermined employment and convex adjustment costs) in NK models helps reconcile the frequent price changes found in the microdata with the degree of sluggishness in inflation adjustment to output changes at the macro level.

Business Cycles in an Estimated DSGE Model of China

A small-scale New-Keynesian dynamic stochastic general equilibrium model is estimated by maximum likelihood method using quarterly data of China. Model specifications and parameter equalities between various competing model variants are addressed by formal statistical hypothesis tests, while implications for business cycle fluctuations are evaluated via a variance decomposition experiment, second-moments matching, and some out-of-sample forecast exercises. It is highlighted that both forward and backward components are important for the dynamics of output, inflation and real balances. The monetary authority will take a sufficient aggressive stance, with a significant lagged response, to the current inflation pressure, while leaving less attention to changes in aggregate output. Variance decomposition reveals that large percentages of variations in real and nominal variables are explained by the highly volatile preference shock and potential output shock, respectively. When nominal and real frictions as well as additional shocks are included, our estimated model overall can successfully reproduce the stylized facts of business cycles in the actual data of China and even frequently outperform those forecasts from an unconstrained VAR.

When are the Effects of Fiscal Policy Uncertainty Large?

Using a new-Keynesian model with endogenous capital accumulation, I show that uncertainty about fiscal policy can cause large declines in consumption, investment, and output when the zero lower bound (ZLB) binds, but has modest effects when the monetary authority is not constrained by the ZLB. I study uncertainty about the level of government spending and uncertainty about tax rates on consumption, wages, capital income, and investment. In my model, uncertainty about government spending and the wage tax rate has particularly large effects. I show that the effects of fiscal policy uncertainty are largest when the nominal interest rate is on the cusp of the ZLB and also that delaying fiscal policy uncertainty diminishes its effects only if the resolution of uncertainty occurs after ZLB no longer binds.