New Keynesian Research Articles

Trend inflation and exchange rate dynamics: A new Keynesian approach

This study examines the exchange rate implications of trend inflation within a two-country New Keynesian (NK) model. An NK Phillips curve generalized by trend inflation makes the inflation differential smoother, more persistent, and less sensitive to the real exchange rate. A Bayesian analysis with post-Bretton Woods data for Canada and the U.S. shows that the model's equilibrium, which relies on Taylor rules with a persistent trend inflation shock and strong policy inertia, mimics empirical regularities in exchange rates that are difficult to reconcile within a standard NK model. Trend inflation helps explain the empirical puzzles of the exchange rate dynamics.

Household heterogeneity and the price puzzle in a new Keynesian model

This paper provides a new insight into the price puzzle using a new Keynesian (NK) model with household heterogeneity. To do this, we adopt a tractable heterogeneous-agent NK (THANK) model that nests the two-agent NK (TANK) and representative-agent NK models. We first demonstrate that when the share of liquidity-constrained (LC) consumers is high, the degree of inflation stabilization in the Taylor rule crucially affects whether the price puzzle occurs in the TANK model. Second, we show that regardless of the share of LC consumers, the price puzzle disappears in the THANK model with a discounted dynamic IS (DIS) curve. In contrast, for a compounded DIS curve, a higher share of LC consumers generates the price puzzle. Finally, we find that even in the case of a compounded DIS curve, reinforced interest rate smoothing can prevent the price puzzle.

New Keynesian and New Classical Debate on Contemporary Macroceconomic Development: Review

This paper analyzes the extended debate between two schools of economic thought – Keynes and Classics with recently updated ideas noted as New Keynesianism (NK) and New Classicism (NC). Here, ideas on Keynesian and classical economics, their similarities, differences, successes, applicability and criticisms has been studied comparatively through descriptive analysis of previous articles from researchers and renowned economists since decades before. The paper suggests that the nomenclature issue between these macroeconomic developments is more than a terminological debate that points out what should be the current issue between Keynesians and Classicals. There are both similarities and differences within the schools of thoughts. The analysis shows the assumptions, criticisms and successes of two of these schools of economic thought viz. NC and NK and explains which of them is appropriate to be applied for assessing policy, monetarism and business cycle theory. Nevertheless, no matter how much they criticize and compete with one another or how many theories and explanations are added, their core remains the same while their applicability always differs in accordance to time and place.

Price setting frequency and the Phillips curve

We develop a New Keynesian (NK) model with endogenous price setting frequency. Whether a firm updates its price is a discrete choice: when expected benefits outweigh expected costs, prices are reset optimally. The model gives rise to a non-linear Phillips curve as prices are more flexible during demand-driven expansions and less so during demand-driven recessions. Monetary policy can have substantial real effects despite the model having a state-dependent pricing component. Our quantitative analysis shows that contrary to the standard NK model, the assumed price setting behavior: (i) is consistent with micro data on price setting frequency; (ii) generates a direct effect of the time-varying price setting frequency on inflation; (iii) creates time-variation in the Phillips curve slope that explains shifts in the Phillips curve associated with different historical episodes; (iv) explains inflation dynamics without relying on implausible high cost-push shocks and nominal rigidities inconsistent with micro data; (v) reconciles the NK model with observed inflation moments.

Government spending multipliers with the Real Cost channel

AbstractIn the benchmark New Keynesian (NK) model, I introduce the real cost channel to study government spending multipliers and provide simple Markov chain closed-form solutions. This model departs fundamentally from most previous interpretations of the nominal cost channel by flattening the NK Phillips Curve in liquidity traps. At the zero lower bound, I show analytically that following positive government spending shocks, the real cost channel can make inflation rise less than in a model without this channel. This then causes a smaller drop in real interest rates, resulting in a lower output gap multiplier. Finally, I confirm the robustness of the real cost channel’s effect on multipliers using extensions of two models.

Reinforcement Learning in a New Keynesian Model

We construct a New Keynesian (NK) behavioural macroeconomic model with bounded-rationality (BR) and heterogeneous agents. We solve and simulate the model using a third-order approximation for a given policy and evaluate its properties using this solution. The model is inhabited by fully rational (RE) and BR agents. The latter are anticipated utility learners, given their beliefs of aggregate states, and they use simple heuristic rules to forecast aggregate variables exogenous to their micro-environment. In the most general form of the model, RE and BR agents learn from their forecasting errors by observing and comparing them with each other, making the composition of the two types endogenous. This reinforcement learning is then at the core of the heterogeneous expectations model and leads to the striking result that increasing the volatility of exogenous shocks, by assisting the learning process, increases the proportion of RE agents and is welfare-increasing.

Evaluation and indirect inference estimation of inattentive features in a New Keynesian framework

AbstractWe test the standard New Keynesian (NK) dynamic stochastic general equilibrium (DSGE) model with and without inattentiveness features, where inattentiveness is modeled either in the form of sticky information (SI) or imperfect information (IF) data revision. All models are estimated and tested by indirect inference. The estimated model with sticky information somewhat outperformed the estimated NK model with full‐information rational expectation (FIRE), though both passed the test easily, while the model with IF data revision was strongly rejected.

Endogenous Technological Change and the New Keynesian Model

Abstract This paper develops and estimates a New Keynesian (NK) model with endogenous technology. It shows that introducing endogenous technology can solve three important puzzles that conventional NK models face: the inflation persistence, disinflationary news shock, and zero lower bound (ZLB) supply shock. First, the observed persistence in inflation is explained without relying on the conventional NK models' additional assumptions (e.g., backward price indexation). Second, it explains the observed disinflationary effect of a news shock. Third, the model avoids the conventional NK models' paradoxical, empirically inconsistent prediction that a negative supply shock is expansionary at the ZLB on interest rates.

Short-Term Planning, Monetary Policy, and Macroeconomic Persistence

We estimate a behavioral New Keynesian (NK) model in which households and firms plan over a finite horizon. The finite-horizon planning (FHP) model outperforms rational expectations versions of the NK model as well as other behavioral NK models. In the FHP model, households and firms are forward-looking in thinking about events over their planning horizon but are backward-looking regarding events beyond that point. This gives rise to substantial aggregate persistence without resorting to additional features such as habit persistence and price contracts indexed to lagged inflation. (JEL E12, E23, E31, E32, E52)

Monetary Policy in a Model of Growth

<ns3:p>Empirical evidence suggests that recessions have long-run effects on the economy's productive capacity. Recent literature embeds endogenous growth mechanisms within business cycle models to account for these "scarring" effects. The optimal conduct of monetary policy in these settings, however, remains largely unexplored. This paper augments the standard sticky-price New Keynesian (NK) to allow for endogenous dynamics in aggregate productivity. The model has a representation similar to the two-equation NK model, with an additional condition linking productivity growth to current and expected future output gaps. Absent state contingency in the subsidies that correct the externalities associated with productivity growth, optimal monetary policy sets inflation above target whenever the subsidies fall short of the externalities. In the recovery from a spell at the ZLB, the optimal discretionary policy sets inflation temporarily above target, helping mitigate the long-run damage. Following a cost-push shock that creates inflationary pressure, the central bank tolerates a larger rise in inflation than in a model with exogenous productivity. The gains from commitment include the central bank's ability to make credible promises about future output gaps in a way that allows it to manipulate current productivity growth.</ns3:p>

Complex dynamics and optimal control of monetary policy in a New Keynesian model with government debt

One of the central tasks of macroeconomic analysis is forecasting and control of economic agents’ expectations for key macroeconomic indicators such as inflation, gross domestic product (GDP), prices and others, etc., so that to achieve maximum level of their welfare through monetary and fiscal policy. This problem is solved within the framework of the optimal control theory using New Keynesian (NK) models that can demonstrate complex behavior, including periodic and chaotic dynamics, even in conditions of dynamical economic equilibrium. Revealing the economic mechanism for the emergence of such irregular dynamics can improve forecasting behavior of the model of the economy and stabilize undesirable dynamics. We consider this complex mechanism from two sides. First, we analyze how various monetary and fiscal policy regimes, active as well as passive, stimulate the emergence of different types of dynamics, both locally determinate and explosive ones, using the NK model with government debt as an example. Second, we clarify how government debt affects optimal monetary policy. A non-trivial backward integration algorithm is implemented to identify the initial state of the model, which leads to optimal dynamic equilibrium and the achievement of targeted values of key macroeconomic indicators.

Shilnikov chaos, low interest rates, and New Keynesian macroeconomics

The paper shows that in a New Keynesian (NK) model, an active interest rate feedback monetary policy, when combined with a Ricardian passive fiscal policy, à la Leeper-Woodford, may induce the onset of a Shilnikov chaotic attractor in the region of the parameter space where uniqueness of the equilibrium prevails locally. Implications, ranging from long-term unpredictability to global indeterminacy, are discussed in the paper. We find that throughout the attractor, the economy lingers in particular regions, within which the emerging aperiodic dynamics tend to evolve for a long time around lower-than-targeted inflation and nominal interest rates. This can be interpreted as a liquidity trap phenomenon, produced by the existence of a chaotic attractor, and not by the influence of an unintended steady state or the Central Bank's intentional choice of a steady state nominal interest rate at its lower bound. In addition, our finding of Shilnikov chaos can provide an alternative explanation for the controversial “loanable funds” over-saving theory, which seeks to explain why interest rates and, to a lesser extent, inflation rates have declined to current low levels, such that the real rate of interest may be below the marginal product of capital. Paradoxically, an active interest rate feedback policy can cause nominal interest rates, inflation rates, and real interest rates unintentionally to drift downwards within a Shilnikov attractor set. Our results are robust to whether money is in the production function, in the utility function, or not in the model at all. But our results do depend upon the existence of sticky prices.

Endogenous Growth, Downward Wage Rigidities and Optimal Inflation

Standard New Keynesian (NK) models feature an optimal inflation target well below two percent, limited welfare losses from business cycle fluctuations and long-term monetary neutrality. We develop a NK framework with labour market frictions, endogenous productivity and downward wage rigidity (DWR) which challenges these results. The model features a non-vertical long-run Phillips curve between inflation and unemployment and a trade-off between price distortions and output hysteresis that change the welfare-maximizing inflation level. For a plausible set of parameters, the optimal inflation target is in excess of two percent, a target value commonly used across central banks. Deviations from the optimal target carry welfare costs multiple times higher than in traditional NK models. The main reason is that endogenous growth and DWR generate asymmetric and hysteresis effects on unemployment and output. Price level targeting or a Taylor-rule responding to the unemployment rate can handle better the asymmetric and hysteresis effects in our model and deliver significant welfare gains. Our results are robust to the inclusion of the effective lower bound on the monetary policy interest rate.

Long-term business relationships, bargaining and monetary policy

We analyze a monetary economy where firms trading intermediate inputs engage in long-term business-to-business (B2B) relationships. We focus on features such as search for business partners, price negotiation and productivity levels that can make it convenient to separate a relationship. These features are introduced into an otherwise standard New Keynesian (NK) model for policy analysis, where the central bank adopts a Taylor rule. As a result of these features of the B2B relationships, final price and intermediate price inflation are generally not aligned, which is realistic but overlooked by the standard NK model. Consequently, we can investigate the extent to which the allocative role of the intermediate price contributes to the transmission of monetary policy shocks. We find that an allocative role arises from the endogenous separations of the relationships. However, this role is smaller than that in the standard NK model, leading to a comparable but micro-founded alternative explanation of the U.S. business cycle moments.

Product Quality, Measured Inflation and Monetary Policy

This paper proposes a tractable New Keynesian (NK) economy with endogenous adjustment in product quality that nests the canonical framework. Endogenous quality choice reduces the slope of the traditional NK Phillips curve and amplifies the economy's response to productivity shocks. This leads to a less reactionary monetary policy where model misspecification of imperfectly observable quality adjustments matters more for macroeconomic stabilization than the mismeasurement of those adjustments. With no misperception of product quality by the monetary authority, the principles for optimal monetary policy are, nonetheless, unchanged as the quality extensions to the canonical NK model preserve divine coincidence.

Delegating Optimal Monetary Policy Inertia in a Small-Open Economy

Abstract This paper explores the delegation of several targeting regimes in a small open new Keynesian (NK) model and examines how central banks overcome stabilization bias in a small open NK model. Results indicate that both speed limit and real exchange rate targeting can carry the isomorphic properties of optimal monetary policy over to the closed economy. In addition, neither nominal income growth targeting nor CPI inflation targeting replicates a commitment policy. These findings provide new implications for optimal monetary policy in an open economy.

The Cyclical Behavior of the Price‐Cost Markup

AbstractA countercyclical markup of price over marginal cost is a key transmission mechanism for demand shocks in New Keynesian (NK) models. This paper reexamines the foundation of those models by studying the cyclicality of the price‐cost markup in the private economy. We find that how the markup is measured matters for its unconditional cyclicality. Measures of the markup based on the inverse of the labor share are moderately procyclical, but are moderately countercyclical for some generalizations of the production function. NK models predict that the cyclicality of the markup should vary depending on the nature of the shock. Consistent with the NK model, we find that the markup is procyclical conditional on total factor productivity shocks and countercyclical conditional on investment‐specific technology shocks. In contrast, we find that the markup increases in response to a positive demand shock. Thus, the transmission mechanism for the effects of demand shocks in sticky‐price NK models is not consistent with the data.

Pegging the interest rate on bank reserves: A resolution of New Keynesian puzzles and paradoxes

Introducing bank reserves (or money) into the basic New Keynesian (NK) model offers a resolution of NK puzzles and paradoxes. The resulting models deliver local-equilibrium determinacy under an exogenous interest rate on reserves and an exogenous nominal stock of reserves, even for an arbitrarily small monetary friction. This leads to a resolution of the forward-guidance puzzle, the fiscal-multiplier puzzle, and the paradox of flexibility. As the monetary friction becomes vanishingly small, the models converge to the basic NK model and serve to select a particular equilibrium of that model - which also offers a resolution of the paradox of toil.

The Missing Link: Monetary Policy and The Labor Share

AbstractThe textbook New Keynesian (NK) model implies that the labor share is procyclical conditional on a monetary policy shock. We present evidence that a monetary policy tightening robustly increased the labor share and decreased real wages during the Great Moderation period in the United States, the Euro Area, the United Kingdom, Australia, and Canada. We show that this is inconsistent not only with the basic NK model, but also with medium-scale NK models commonly used for monetary policy analysis and where it is possible to break the direct link between the labor share and the inverse markup. Our results imply that either NK models are unable to separate the dynamics of the labor share from the markup or markups do not respond in the way NK models predict.

Monetary and Macroprudential Policy with Endogenous Risk

We extend the New Keynesian (NK) model to include endogenous risk. Lower interest rates not only shift consumption intertemporally but also conditional output risk via their impact on risk-taking, giving rise to a vulnerability channel of monetary policy. The model fits the conditional output gap distribution and can account for medium-term increases in downside risks when financial conditions are loose. The policy prescriptions are very different from those in the standard NK model: monetary policy that focuses purely on inflation and output-gap stabilization can lead to instability. Macroprudential measures can mitigate the intertemporal risk-return tradeoff created by the vulnerability channel.