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You are on page 1of 30

**Graduate Macro II, Spring 2010
**

The University of Notre Dame

Professor Sims

1 Introduction

This document lays out the standard New Keynesian model based on Calvo (1983) staggered

price-setting. The basic model is usually cast in a setting without physical capital, which

means that there is no way in equilibrium to transfer resources across time (i.e. in equilibrium

aggregate consumption is equal to output). Some argue that this isn’t a problem, but I

think it makes the model behave very di¤erently. Aside from lacking physical capital, the

model also di¤ers from our benchmark in that it assumes imperfect competition (in particular

monopolistic competition) on the …rm side of the model. To think about price-stickiness

you have to think about price-setting, and to think about price-setting you need some degree

of pricing power. The household side of the model is basically identical to what we’ve seen

before.

I’ll begin with a model of imperfect competition with no price stickiness. Then we’ll

move to a model with price-stickiness.

2 The Model with No Price Stickiness

2.1 Households

The household side of the model is very standard and is similar to setups we have already

seen. We assume that money enters the utility function in order to get households to hold

money. The household’s problem can be written as follows:

max

ct,at,bt,nt

1

0

1

t=0

,

t

_

c

1o

t

÷1

1 ÷o

+ o

(1 ÷:

t

)

1¸

÷1

1 ÷¸

+ ·

:

1·

t

÷1

1 ÷·

_

s.t.

c

t

+ /

t

+ :

t

_ n

t

:

t

+

t

+ (1 + i

t1

)

/

t1

1 + :

t

+

:

t1

1 + :

t

The Lagrangian for the problem can be written:

/ = 1

0

1

t=0

,

t

_

_

_

c

1

t

1

1o

+ o

(1at)

1

1

1¸

+ ·

n

1v

t

1

1·

+ ...

... + `

t

_

n

t

:

t

+

t

+ (1 + i

t1

)

b

t1

1+¬t

+

n

t1

1+¬t

÷c

t

÷/

t

÷:

t

_

_

_

_

1

The …rst order conditions can be written:

J/

Jc

t

= 0 =c

o

t

= `

t

J/

J:

t

= 0 =o(1 ÷:

t

)

¸

= `

t

n

t

J/

J/

t

= 0 =`

t

= ,`

t+1

1 + i

t

1 + :

t+1

J/

J:

t

= 0 =,

t

·:

·

t

÷,

t

`

t

+ ,

t+1

`

t+1

1

1 + :

t+1

= 0

= ·:

·

t

= `

t

÷,`

t+1

1

1 + :

t+1

We can simplify these using the Fisher relationship and simplifying:

(1 ÷:

t

)

¸

= c

o

t

n

t

c

o

t

= ,c

o

t+1

(1 + :

t

)

·:

·

t

= c

o

t

_

i

t

1 + i

t

_

2.2 Production

Production in these models is split into two stages – intermediate and …nal goods. The …nal

goods production “technology” is simply a constant elasticity (CES) bundler of intermediate

goods – there are no factors (i.e. labor) used to produce …nal goods. Pro…t maximization

in the …nal goods sector (which is competitive) yields a downard sloping demand curve for

intermediate goods producers, which gives themsome pricing power. It is in the intermediate

goods sector that we will assume some nominal rigidity (i.e. price-stickiness), which is in

turn capable of generating meaningful non-neutralities.

What di¤erentiates monopolistic competition from perfect competition is that a large

number …rms sell di¤erentiated products and have some pricing power. Because of entry

and exit, they earn no economic pro…ts in the long run, however.

2.2.1 Final Goods

There is one …nal goods …rm and a continuum (i.e. in…nity) of intermediate goods …rms.

These …rms are indexed along the unit interval. The “production function” for the …nal

good is:

¸

t

=

_

_

1

_

0

¸

t

(,)

"1

"

d,

_

_

"

"1

We require that 1; this is the elasticity of substitution among the di¤erent intermediate

goods. As long as < ·, the intermediate goods are imperfect substitutes in consumption;

2

this is what gives them market power. Note that an integral is really just a sum – we’re

just taking a weighted sum of intermediate goods and then raising them all to a power. It

is straightforward to verify that this “production function” has constant returns to scale –

if you double all intermediate inputs, you double output.

The …nal goods …rm wants to maximize pro…ts (more generally they’d want to maxi-

mize the present discounted value of pro…ts, but there is nothing that makes the problem

interesting in a dynamic sense as they just buy the intermediate goods period by period,

so maximizing value is equivalent to maximizing pro…ts period by period). The objective

function is written in nominal terms is:

max

jt())

j

t

¸

t

÷

1

_

0

j

t

(,)¸

t

(,)d,

Total revenue is the …nal goods price times the amount of …nal good. Total cost is the sum

over all intermediate goods of the price times quantity. Plug in the production function:

max

jt())

j

t

_

_

1

_

0

¸

t

(,)

"1

"

d,

_

_

"

"1

÷

1

_

0

j

t

(,)¸

t

(,)d,

The …rst order conditions come from taking the derivative with respect to each ¸

t

(,) and

setting it equal to zero. Remember to treat the integral just like a sum in taking the

derivatives.

j

t

÷1

_

_

1

_

0

¸

t

(,)

"1

"

d,

_

_

"

"1

1

÷1

¸

t

(,)

"1

"

1

= j

t

(,) \ ,

Now play around with this and simplify and solve for the demand for each intermediate

good:

3

j

t

_

_

1

_

0

¸

t

(,)

"1

"

d,

_

_

"

"1

"1

"1

¸

t

(,)

"1

"

"

"

= j

t

(,) \ ,

j

t

_

_

1

_

0

¸

t

(,)

"1

"

d,

_

_

1

"1

¸

t

(,)

1

"

= j

t

(,) \ ,

¸

t

(,)

1

"

=

_

j

t

(,)

j

t

_

_

_

1

_

0

¸

t

(,)

"1

"

d,

_

_

1

"1

¸

t

(,) =

_

j

t

(,)

j

t

_

.

_

_

1

_

0

¸

t

(,)

"1

"

d,

_

_

"

"1

¸

t

(,) =

_

j

t

(,)

j

t

_

.

¸

t

The last line follows from the de…nition of the …nal goods CES aggregator. This says that

the demand for each intermediate good depends negatively on its relative price and positively

on total production. We can interpret as the elasticity of demand – the requirement that

1 is just say that monopolists produce on the elastic portion of the demand curve. As

÷ · demand becomes perfectly elastic (equivalently, the intermediate goods are perfect

substitutes), which will end up putting us back in the case of perfect competition.

Since the …nal good …rm is competitive, pro…ts are zero, which implies that:

j

t

¸

t

=

1

_

0

j

t

(,)¸

t

(,)d,

Plug in the demand functions for intermediate goods and solve for the price of the …nal good:

j

t

¸

t

=

1

_

0

j

t

(,)

_

j

t

(,)

j

t

_

.

¸

t

d,

We can “take out of the integral” (i.e. sum) the variables not indexed by , on the right

hand side, leaving:

4

j

t

¸

t

= j

.

t

¸

t

1

_

0

j

t

(,)

1.

d,

j

1.

t

=

1

_

0

j

t

(,)

1.

d,

j

t

=

_

_

1

_

0

j

t

(,)

1.

d,

_

_

1

1"

This can be thought of as the aggregate price index.

2.2.2 Intermediate Goods

Intermediate goods (remember, there an in…nite number of them populated along the unit

interval) produce output using a production function using labor and TFP. The level of

TFP is common to all of them. Assume that this production function takes the form:

¸

t

(,) = c

t

:

t

(,)

Hence, production is linear in labor given TFP.

The typical intermediate goods …rm optimizes along two dimensions – it must choose its

employment and its price. We consider these problems sequentially.

Intermediate goods …rms are price takers in factor markets (i.e. they take the wage as

given). The market structure requires them to produce as much output as is demanded at a

given price (they will be willing to do this since price, as we will show, will be above marginal

cost). Nothing makes the value of the …rm explicitly time dependent (i.e. …rm’s don’t have

factor attachment), so maximizing value is equivalent to maximizing pro…ts period by period,

which is in turn equivalent to minimizing costs period by period. It is easiest to think about

the choice over labor as a cost minimization problem as follows:

min

at())

\

t

:

t

(,)

s.t.

¸

t

(,) _

_

j

t

(,)

j

t

_

.

¸

t

¸

t

(,) = c

t

:

t

(,)

Here, \

t

is the nominal wage, which is common to all …rms since they are competitive in

factor markets. Pro…ts are maximized when costs are minimized subject to two constraints

– production is at least as much as demand and production is governed by the production

5

“technology” given above. Minimzing a function is the same as maximizing the negative of

the same function, so we can write the problem out as a standard Lagrangian:

/ = ÷\

t

:

t

(,) + ,

t

_

c

t

:

t

(,) ÷

_

j

t

(,)

j

t

_

.

¸

t

_

The …rst order condition is:

\

t

= ,

t

c

t

The Lagrange multiplier, ,

t

, has the interpretation of nominal marginal cost – how much

nominal costs change (the objective function) if the constraint is relaxed (i.e. if the …rm

has to produce one more unit of its good). note that marginal cost is not indexed by , –

constant returns to scale plus competitive factor markets insure that marginal cost is the

same for all …rms. Divide both sides of this expression by the aggregate price level (this

puts this in terms of the consumption wage, which is what households care about). This

leaves a relationship between the real wage, real marginal cost, and the marginal product of

labor.

n

t

=

,

t

j

t

c

t

Here n

t

=

Wt

jt

; i.e. the real wage. If markets were perfectly competitive, price would always

be equal to marginal cost, and so real marginal cost would always be one, and the labor

demand condition would be the familiar wage equals marginal product. More generally, real

marginal cost will equal the real wage divided by the marginal product of labor.

Now consider the choice of the optimal price conditional on the optimal choice of labor.

Again, since the …rm can choose its price each and every period, we can write this as a static

problem.

max

jt())

j

t

(,)¸

t

(,) ÷\

t

:

t

s.t.

¸

t

(,) =

_

j

t

(,)

j

t

_

.

¸

t

\

t

= ,

t

c

t

In other words, the optimization is done subject to the demand function and the require-

ment that labor is chosen optimally. Techinically, we should be maximizing real pro…ts,

which would entail dividng by the aggregate price level, but given the static nature of the

problem, doing so would not a¤ect the optimal decision rule. We can plug these constraints

in to write the problem as:

max

jt())

j

t

(,)

_

j

t

(,)

j

t

_

.

¸

t

÷,

t

c

t

:

t

= j

t

(,)

_

j

t

(,)

j

t

_

.

¸

t

÷,

t

_

j

t

(,)

j

t

_

.

¸

t

6

Since the …rm is small (i.e. there are an in…nite number of them), it takes aggregate

output, ¸

t

, and the aggregate price level as given. Take the FOC:

(1 ÷)j

t

(,)

.

j

.

t

¸

t

+ ,

t

j

t

(,)

.1

j

.

t

¸

t

= 0

Simplifying:

( ÷1)j

t

(,)

.

= ,

t

j

t

(,)

.1

j

t

(,) =

÷1

,

t

Since 1,

.

.1

1. This means that the optimal price is a markup over marginal cost

(i.e. price exceeds marginal cost). The extent of the markup depends on how “steep” the

…rm’s demand curve is. As ÷·, the …rm faces a horizontal demand curve,

.

.1

÷1, and

price is equal to marginal cost, and we’re back in the perfectly competitive case.

2.3 Aggregation

We will restrict attention to a situation in which all …rms behave identically (i.e. a “symmet-

ric equilibrium”). This is not without loss of generality. Since …rms operate in competitive

factor markets, they all have the same marginal cost of production, ,

t

. Since they all face

the same demand elasticity, from above, we see that they will all choose the same price. But

if they all choose the same price, they face the exact same demand. This in turn means

that they will each produce an equal amount and will hire an equal amount of labor (since

they all face the same aggregate TFP). Starting with the aggregate production function, we

have:

¸

t

=

_

_

1

_

0

¸

t

(,)

"1

"

d,

_

_

"

"1

Let ¸

t

(,) be the amount of output produced by the typical intermediate goods …rm.

Since it’s the same across all ,, we have can take it out of the integral and get:

¸

t

= ¸

t

(,)

_

_

1

_

0

d,

_

_

"

"1

= ¸

t

(,)

In other words, output of the …nal good is equal to output of the intermediate goods

(or, more correctly, the production of the …nal good is equal to the sum of production of

intermediate goods in the symetric equilibrium . . . since we are summing across the unit

interval, the sum is equal to the amount produced by any one …rm on the unit interval).

Taking note of this fact, and using the intermediate goods production function, we have

¸

t

= ¸

t

(,) = c

t

:

t

(,)

7

Note also that, since we’re integrating over the unit interval and every …rm produces the

same amount, ¸

t

(,) =

1

_

0

¸

t

(,)d,. Hence we can apply an integral above and get:

¸

t

=

1

_

0

c

t

:

t

(,)d, = c

t

1

_

0

:

t

(,)d, = c

t

:

t

This follows from the fact that employment supplied by the houshold is split amount the

…rms along the unit interval (i.e. :

t

=

1

_

0

:

t

(,)d,).

Since all intermediate goods …rms are behaving the same, we get the same result that

the aggregate price level is equal to the price level of the intermediate goods …rm:

j

t

= j

t

(,)

From above, we know what each …rm’s price will be:

j

t

(,) =

÷1

,

t

The labor demand condition for each intermediate goods …rm is:

\

t

= ,

t

c

t

Divide both sides by the price level:

n

t

=

,

t

j

t

c

t

Now use the pricing condition:

n

t

=

÷1

c

t

.1

.

< 1, so the real wage is less than the marginal product.

We can summarize the entire model with the following equations:

c

o

t

= ,1

t

c

o

t+1

(1 + :

t

) (1)

c

t

= ¸

t

(2)

¸

t

= c

t

:

t

(3)

o(1 ÷:

t

)

¸

= c

o

t

n

t

(4)

n

t

=

÷1

c

t

(5)

8

·:

·

t

= c

o

t

_

i

t

1 + i

t

_

(6)

1 + :

t

=

1 + i

t

1 + :

t+1

(7)

d:

t

+ :

t

= (1 ÷j

n

):

+ j

n

d:

t1

+ j

n

:

t1

+ c

n,t

(8)

d:

t

= ln :

t

÷ln :

t1

(9)

ln c

t

= j ln c

t1

+ c

o,t

(10)

(1) is the Euler equation; (2) is the aggregate accounting identity; (3) is the production

function; (4) is labor supply; (5) is labor demand; (6) is demand for real balances; (7) is the

Fisher relationship; (8) is the exogenous process governing the growth rate of real balances;

(9) de…nes the growth rate of real balances; and (10) is the familiar process for log technology.

3 The Model with Calvo Price Stickiness

Above …rms could change their prices each period; each period, they would set prices as a

constant markup over marginal cost, with the size of the markup related to the slope of the

demand curve for their good. Now we assume that …rms cannot change their prices freely

each period. In particular, …rms face a constant probability, 1 ÷c, of being able to adjust

their price in any period. This hazard rate is constant across time.

The household side of the model is identical to above; the …nal goods production is also

identical to above. The pricing decision is simlar but cannot be undertaken every period.

Let’s consider a …rm who, at time t, is given the ability to adjust its price. It will do so to

maximize the expected discounted value of pro…ts, since it will, in expectation, be stuck with

this price for more than just the current period. The …rm discounts future pro…ts by the

gross real interest rate between today and future dates . . . i.e. (1 +:

t,t+c

)

1

for : = 0. ...·.

From the households Euler equation, we can solve for this “long” real interest rate as:

(1 + :

t,t+c

)

1

= ,

c

1

t

_

c

t+c

c

t

_

o

This is often called the stochastic discount factor and is frequently used in the asset pricing

literature. In addition, the …rm will also discount future pro…t ‡ows by the probability that

it will be stuck with the price it chooses today. This probability is c. If c is small, then the

…rms get to update their prices frequently, and thus will heavily discount future pro…t ‡ows

when making current pricing decisions. On the other hand, if c is large, it is very likely that

a …rm will be “stuck” with whatever price it chooses today for a long time, and will thus be

relatively more concerned about the future when making its current pricing decisions.

Similarly to above but now taking account of the possibility of being stuck with a price,

we can write the …rm with the opportunity to change its price solves the following problem:

9

max

jt())

1

t

1

c=0

(c,)

c

t,t+c

_

j

t

(,)

j

t+c

_

j

t

(,)

j

t+c

_

.

¸

t+c

÷

,

t+c

j

t+c

_

j

t

(,)

j

t+c

_

.

¸

t+c

_

Here the problem is written as maximizing real pro…ts discounted by the stochastic

discount factor as well as the probability of being able to make price changes. For simplicity,

I write

t,t+c

=

_

c

t+s

ct

_

o

– i.e. the ratio of marginal utility between period t +: and period

t. When c = 0, so that there is no price stickiness, it is straightforward to verify that the

problem reduces to what we had above (because (c,)

c

= 0 for every : 0, so only current

pro…ts will factor into the pricing decision. Note that the …rm’s price isn’t indexed by :,

since it is choosing a price today that it won’t be able to change in the future. The …rst

order condition for this problem is:

1

t

1

c=0

(c,)

c

t,t+c

_

(1 ÷)j

t

(,)

.

j

(1.)

t+c

¸

t+c

+ j

t

(,)

.1

,

t+c

j

(1.)

t+c

¸

t+c

_

= 0

Let’s simplify:

1

t

1

c=0

(c,)

c

t,t+c

_

( ÷1)j

t

(,)

.

j

(1.)

t+c

¸

t+c

_

= 1

t

1

c=0

(c,)

c

t,t+c

_

j

t

(,)

.1

,

t+c

j

(1.)

t+c

¸

t+c

_

Since the price they choose does not depend upon :, we can pull it out of the sums:

(÷1)j

t

(,)

.

1

t

1

c=0

(c,)

c

t,t+c

_

j

(1.)

t+c

¸

t+c

_

= j

t

(,)

.1

1

t

1

c=0

(c,)

c

t,t+c

_

,

t+c

j

(1.)

t+c

¸

t+c

_

Simplify:

j

#

t

=

÷1

1

t

1

c=0

(c,)

c

t,t+c

_

,

t+c

j

(1.)

t+c

¸

t+c

_

1

t

1

c=0

(c,)

c

t,t+c

_

j

(1.)

t+c

¸

t+c

_

Above, I replace the j

t

(,) with j

#

t

, which is called the optimal reset price. Since …rms face

the same marginal cost and take aggregate variables as given, any …rm that gets to update its

price will choose the same price. Essentially, the current price that price-changing …rms will

choose is a present discount value of marginal costs. As noted, if there is no price-stickiness,

so that c = 0, then the solution is the same as above, with j

#

t

=

.

.1

,

t

.

For ease of notation, let’s write this expression as:

10

j

#

t

=

÷1

¹

t

1

t

¹

t

= 1

t

1

c=0

(c,)

c

t,t+c

_

,

t+c

j

(1.)

t+c

¸

t+c

_

1

t

= 1

t

1

c=0

(c,)

c

t,t+c

_

j

(1.)

t+c

¸

t+c

_

Now, when we go to the computer to solve this, the computer isn’t going to like an in…nite

sum. Fortunately, we can write the expression for ¹

t

and 1

t

as follows:

¹

t

= ,

t

j

(1.)

t

¸

t

+ c,

t,t+1

1

t

¹

t+1

1

t

= j

(1.)

t

¸

t

+ c,

t,t+1

1

t

1

t+1

Recall the de…nition of the aggregate price level:

j

t

=

_

_

1

_

0

j

t

(,)

1.

d,

_

_

1

1"

We can split this intergral into a convex combination of two things – the optimal reset

price and the previous price. This is because all …rms that can reset will choose the same

reset price, and the “average” price of the …rms that cannot reset will equal the previous

aggregate price level:

j

t

=

_

_

1

_

0

_

(1 ÷c)j

#1.

t

+ cj

1.

t1

_

d,

_

_

1

1"

j

t

=

_

_

1ç

_

0

j

#1.

t

d, +

1

_

1ç

j

1.

t1

d,

_

_

1

1"

j

t

=

_

(1 ÷c)j

#1.

t

+ cj

1.

t1

_ 1

1"

As a general matter we want to allow for the existence of steady state in‡ation (though

in most linearizations it is assumed that there is zero steady state in‡ation), so we need to

write this such that there is a well-de…ned steady state. To do this divide both sides by

j

t1

:

11

j

t

j

t1

= j

1

t1

_

(1 ÷c)j

#1.

t

+ cj

1.

t1

_ 1

1"

j

t

j

t1

=

_

j

(1.)

t1

((1 ÷c)j

#1.

t

+ cj

1.

t1

)

_ 1

1"

j

t

j

t1

=

_

_

(1 ÷c)

_

j

#

t

j

t1

_

1.

+ c

_

j

t1

j

t1

_

1.

_

_

1

1"

De…ning 1 + :

t

=

jt

j

t1

, we can write this:

1 + :

t

=

_

_

(1 ÷c)

_

j

#

t

j

t1

_

1.

+ c

_

_

1

1"

Thus, to get an expression for current in‡ation, we need to …nd an expression for “reset

price in‡ation”, which I’ll call

j

#

t

j

t1

. Go back to the expression for the rest price:

j

#

t

=

÷1

¹

t

1

t

Divide both sides by j

t1

:

j

#

t

j

t1

=

÷1

1

j

t1

¹

t

1

t

Let’s deal with this part by part. Note that:

¹

t

j

t1

=

1

j

t1

_

,

t

j

(1.)

t

¸

t

+ c,

t,t+1

1

t

¹

t+1

_

¹

t

j

t1

=

,

t

j

(1.)

t

¸

t

j

t1

+

c,

t,t+1

1

t

¹

t+1

j

t1

De…ning :c

t

=

,

t

jt

as real marginal cost, we can write this as:

¹

t

j

t1

= :c

t

_

j

t

j

t1

_

j

(1.)

t

¸

t

+

c,

t,t+1

1

t

¹

t+1

j

t1

We need to play around further with the dates on the very end of the expression on the

right hand side:

¹

t

j

t1

= :c

t

_

j

t

j

t1

_

j

(1.)

t

¸

t

+ c,

t,t+1

_

j

t

j

t1

_

1

t

¹

t+1

j

t

To save on notation, let’s go ahead and call

¹t

j

t1

=

´

¹

t

. Thus, we can write this as:

´

¹

t

= (1 + :

t

)

_

:c

t

j

(1.)

t

¸

t

+ c,

t,t+1

´

¹

t+1

_

12

Given this, we can write reset price in‡ation as:

j

#

t

j

t1

=

÷1

´

¹

t

1

t

Now, we’re not yet done because both

´

¹

t

and 1

t

have a j

(1.)

t

component in them.

Fortunately, we can divide both numerator and denominator by j

(1.)

t

without changing

the equality. De…ne ´c

t

=

´

¹

t

,j

(1.)

t

and

´

/

t

= 1

t

,j

(1.)

t

:

j

#

t

j

t1

=

÷1

´c

t

´

/

t

Now we need to …nd expression for ´c

t

and

´

/

t

:

´c

t

=

´

¹

t

j

(1.)

t

= (1 + :

t

)

_

:c

t

¸

t

+ 1

t

c,

t,t+1

´

¹

t+1

j

(1.)

t

_

´c

t

=

´

¹

t

j

(1.)

t

= (1 + :

t

)

_

:c

t

¸

t

+ 1

t

c,

t,t+1

_

j

t+1

j

t

_

(1.)

´

¹

t+1

j

(1.)

t+1

_

´c

t

= (1 + :

t

)

_

:c

t

¸

t

+ 1

t

c,

t,t+1

(1 + :

t+1

)

(1.)

´c

t+1

_

´

/

t

=

1

t

j

(1.)

t

=

1

j

(1.)

t

_

j

(1.)

t

¸

t

+ 1

t

c,

t,t+1

1

t+1

_

´

/

t

= ¸

t

+ 1

t

c,

t,t+1

1

t+1

j

(1.)

t

´

/

t

= ¸

t

+ 1

t

c,

t,t+1

_

j

t+1

j

t

_

(1.)

1

t+1

j

(1.)

t+1

´

/

t

= ¸

t

+ 1

t

c,

t,t+1

(1 + :

t+1

)

(1.)

´

/

t+1

A small technical point is that, for this “trick” to work (i.e. writting ´c

t

and

´

/

t

not as

in…ninite sums but rather as as current plus “continuation values”) it must be the case that

the e¤ective discount factor be less than one in the steady state. Since

= 1, this means

that c, (1 + :

)

(1.)

< 1. c, < 1, so if steady state in‡ation is zero, this is never an issue.

But if steady state in‡ation is very high, or is very large, then this may not hold. Given

the auxilliary variables ´c

t

and

´

/

t

, which, subject to the caveat above, have been rendered

stationary, we can write actual price in‡ation as:

1 + :

t

=

_

_

(1 ÷c)

_

j

#

t

j

t1

_

1.

+ c

_

_

1

1"

j

#

t

j

t1

=

÷1

´c

t

´

/

t

13

Given this, we can write down the equations characterizing equilibrium of the model with

price stickiness as follows:

c

o

t

= ,1

t

c

o

t+1

(1 + :

t

) (11)

c

t

= ¸

t

(12)

¸

t

= c

t

:

t

(13)

o(1 ÷:

t

)

¸

= c

o

t

n

t

(14)

n

t

= :c

t

c

t

(15)

1 + :

t

=

_

(1 ÷c)

_

1 + :

#

t

_

1.

+ c

_ 1

1"

(16)

1 + :

#

t

=

÷1

´c

t

´

/

t

(17)

´c

t

= (1 + :

t

)

_

:c

t

¸

t

+ 1

t

c,

t,t+1

(1 + :

t+1

)

(1.)

´c

t+1

_

(18)

´

/

t

= ¸

t

+ 1

t

c,

t,t+1

(1 + :

t+1

)

(1.)

´

/

t+1

(19)

t,t+1

=

_

c

t+1

c

t

_

o

(20)

·:

·

t

= c

o

t

_

i

t

1 + i

t

_

(21)

1 + :

t

=

1 + i

t

1 + :

t+1

(22)

d:

t

+ :

t

= (1 ÷j

n

):

+ j

n

d:

t1

+ j

n

:

t1

+ c

n,t

(23)

d:

t

= ln :

t

÷ln :

t1

(24)

ln c

t

= j ln c

t1

+ c

t

(25)

Note that I have …fteen equations and …fteen variables. Some of these (in fact many of

these) variables can be eliminated from the solution.

I calibrate the parameters of the model as follows:

14

Parameter Value

, 0.99

o 1

¸ 1

· 1

o 3.5

c 0.75

j 0.9

j

n

0.5

· 1

11

:

0.01

o

c

0.007

o

cn

0.002

How can these parameters be interpreted? The discount factor of 0.99 implies a steady

state real interest rate of about one percent (or about four percent expressed at an annual

frequency). Coupled with steady state in‡ation of 0.01, this means that the steady state

nominal interest rate is about 0.02. The power coe¢cients in preferences being all equal to

one means that the within period utility function is “log-log-log”. o = 3.5 means that steady

state hours per capita will be roughly 0.2. The shock standard deviations and autoregressive

coe¢cients in the technology and money growth speci…cations are similar to what we’ve been

using.

The two new parameters here that need some discussion are c, which governs price-

stickiness and is often called the “Calvo parameter”, and , which controls market power.

is easier to deal with, so we begin there. Recall from our derivation that the steady state (or

average) markup of price over marginal cost is equal to

.

.1

. In the data, average markups

appear to be about 10% (Basu and Fernald (1997)). This means that

.

.1

= 1.1, or = 11.

The Calvo parameter will govern the average duration between price changes. Condi-

tional on changing a price in the current period, what is the expected duration until your

next price change? Well, the probability of getting to change prices next period is 1 ÷ c.

The probability of getting to change prices in two periods is 1 ÷ c times the probability of

not changing prices after one period, or (1 ÷ c)c. The probability of getting to change

prices in three periods is 1 ÷c times the probability of not getting to change prices for two

consecutive periods, or (1 ÷c)c

2

. More compactly:

Duration Probability

1 1 ÷c

2 (1 ÷c)c

3 (1 ÷c)c

2

4 (1 ÷c)c

3

.

.

.

.

.

.

, (1 ÷c)c

)1

15

The expected duration between price changes is then just the sum of probabilities times

duration:

Expected Duration between Price Changes =

1

)=1

(1 ÷c)c

)1

,

= (1 ÷c)

1

)=1

c

)1

,

We can write the part inside the summation as:

o = 1 + 2c + 3c

2

+ 4c

3

+ 5c

4

+ ... =

1

)=1

c

)1

,

Multiply everything by c:

oc = c + 2c

2

+ 3c

3

+ 4c

4

+ 5c

5

+ ...

Subtract the former from the latter:

o ÷oc = 1 + (2 ÷1)c + (3 ÷2)c

2

+ (4 ÷3)c

3

+ (5 ÷4)c

4

+ ....

(1 ÷c)o = 1 + c + c

2

+ c

3

+ c

4

+ ....

Now multiply this expression by c:

(1 ÷c)co = c + c

2

+ c

3

+ c

4

+ ....

Now subtract this from the former:

(1 ÷c)o ÷(1 ÷c)co = 1

This follows from the fact that, as , ÷·, c

)+1

= c

)

= 0. Simplifying:

(1 ÷c)

2

o = 1

o =

1

(1 ÷c)

2

Now plugging this back in to the original expression, we have:

Expected Duration between Price Changes = (1 ÷c)

1

(1 ÷c)

2

=

1

(1 ÷c)

Thus, we can calibrate c by looking at data on the average duration between price

changes. Bils and Klenow (2004) …nd that it’s between 6 months and one year. We’ll go

with the long end of that range (four quarters), which suggests that c = 0.75.

Below are impulse responses to technology shock:

16

We see that a technology shock leads to an increase in output and the real interest rate

on impact, with decreases in in‡ation, hours, and the price level. The fall in hours may

seem non-intuitive at …rst. To see why hours fall, look at the money demand speci…cation:

·:

·

t

= c

o

t

_

i

t

1 + i

t

_

Rewrite this in terms of the nominal money supply, the price level, and output (since

consumption is equal to output in equilibrium):

_

`

t

j

t

_

= ¸

v

t

·

1

v

_

1 + i

t

i

t

_1

v

To make this as simple to see as possible, suppose that both · and o are very big, so

that

o

·

- 1 and

1

·

- 0. Then we recover exactly the simple quantity equation:

`

t

= j

t

¸

t

If prices were fully ‡exible, when technology increases prices would fall by the amount of

the increase in output. But because we have here assumed price stickiness, prices cannot

fall by that much, so output cannot rise by as much as it would if prices were fully ‡exible.

This means that hours cannot rises by as much as they do when prices are fully ‡exible; since

in the way I wrote down preferences hours actually do not respond at all to a technology

shock when prices are perfectly ‡exible, this necessitates a decrease in hours on impact.

Next, consider the responses to a money growth shock.

17

These responses look reasonably intuitive. An increase in money growth raises output,

in‡ation, and the price level, while lowering nominal and real interest rates. The intuition

for why this happens can be gained from the quantity theoretic equation above as well. The

price level cannot adjust upward the same amount it would if prices were ‡exible when the

money supply increases – therefore, output must rise to make the money market clear. Note

that the Matlab …led used to produce these …gures is titled nk_basic_notzero.mod and can

be run from new_keynesian.m.

3.0.1 Log-Linearizing

Suppose that we want to log-linearize this expression about a steady state. The conventional

linearization is about the zero in‡ation steady state, so that :

**= 0. AS short hand, let’s
**

call

j

#

t

j

t1

= 1 + :

#

t

. Log-linearize the in‡ation equation by …rst taking logs of both sides:

ln(1 + :

t

) =

1

1 ÷

ln

_

(1 ÷c)

_

1 + :

#

t

_

1.

+ c

_

Now do the Taylor series expansion about the point :

**= 0, which will mean :
**

#

= 0 as

well:

ln(1 + 0) +

d:

t

1 + 0

=

1

1 ÷

ln(1) +

1

1 ÷

1

1

(1 ÷)(1 ÷c)(1 + 0)

.

d:

#

t

Some of this follows from the fact that (1 ÷c) (1 + 0)

1.

+ c = 1. Simplify, we have:

d:

t

= (1 ÷c)d:

#

t

18

Since in‡ation is already in a percentage rate, we want to leave it as an absolute rather

than percentage deviation. Therefore, let ¯ :

t

= d:

t

and ¯ :

#

t

= d:

#

t

:

¯ :

t

= (1 ÷c)¯ :

#

t

Quite naturally, then, this says that deviation of in‡ation from 0 is equal to the fraction

of …rms changing prices times the amount by which they are changing prices. To close this

out, we now need an expression for ¯ :

#

t

. Log-linearize that expression by …rst taking logs:

ln(1 + :

#

t

) = ln ÷ln( ÷1) + ln´c

t

÷ln

´

/

t

Now do a Taylor series expansion about the zero in‡ation steady state:

ln(1 + 0) + d:

#

t

= ln ÷ln( ÷1) + ln´c

÷ln

´

/

+

d´c

t

´c

÷

d

´

/

t

´

/

¯ :

#

t

= ln ÷ln( ÷1) + ln

_

´c

´

/

_

+

¯

´c

t

÷

¯

´

/

t

Where ¯ :

#

t

= d:

#

t

. Now, what is

bo

b

b

? Note that

t,t+1

= 1. Solve for them individually

using the de…nitions:

´c

t

= (1 + :

t

)

_

:c

t

¸

t

+ 1

t

c,

t,t+1

(1 + :

t+1

)

(1.)

´c

t+1

_

´c

= :c

¸

+ c,´c

´c

=

:c

¸

1 ÷c,

´

/

t

=

_

¸

t

+ 1

t

c,

t,t+1

(1 + :

t+1

)

(1.)

´

/

t+1

_

´

/

= ¸

+ c,

´

/

´

/

=

¸

1 ÷c,

To derive the above I’m using the assumption that in‡ation is zero in the steady state.

Thus, I have:

´c

´

/

= :c

**From above, we know that price is equal to a markup over nomina marginal cost. Thus
**

real marginal cost is equal to the inverse of that markup, or, in the steady state:

:c

=

÷1

**This means that:
**

19

ln

_

´c

´

/

_

= ln( ÷1) ÷ln

Now plugging this in above, we see that the s disappear, leaving:

¯ :

#

t

=

¯

´c

t

÷

¯

´

/

t

So now we need

¯

´c

t

and

¯

´

/

t

. Begin with the …rst by …rst taking logs:

´c

t

= (1 + :

t

)

_

:c

t

¸

t

+ 1

t

c,

t,t+1

(1 + :

t+1

)

(1.)

´c

t+1

_

ln´c

t

= ln(1 + :

t

) + ln

_

:c

t

¸

t

+ 1

t

c,

t,t+1

(1 + :

t+1

)

(1.)

´c

t+1

_

Now do the Taylor series expansion evaluated at the steady state. Before proceeding,

note that :c

¸

+ 1

t

c,´c

= ´c

**since steady state in‡ation is 0:
**

ln´c

+

d´c

t

´c

= ln(1 + 0) + d:

t

+ ln´c

+

d:c

t

¸

´c

+

d¸

t

:c

´c

+ ...

... +

c,d

t,t+1

´c

´c

÷

(1 ÷)c,d:

t+1

´c

´c

+

c,d´c

t+1

´c

Simplifying, we have:

¯

´c

t

= d:

t

+

d:c

t

¸

´c

+

d¸

t

:c

´c

+ cd

t,t+1

÷(1 ÷)c,d:

t+1

+ c,

¯

´c

t+1

Leave this alone for a minute. Now go to

¯

´

/

t

:

ln

´

/

t

= ln

_

¸

t

+ 1

t

c,

t,t+1

(1 + :

t+1

)

(1.)

´

/

t+1

_

As above, note that ¸

+ 1

t

c,

´

/

=

´

/

**. Proceed with the …rst order Taylor series
**

expansion:

ln

´

/

+

d

´

/

t

´

/

= ln

´

/

+

d¸

t

´

/

+ +

c,d

t,t+1

´

/

´

/

÷

(1 ÷)c,d:

t+1

´

/

´

/

+

c,d

´

/

t+1

´

/

**Now simplify some:
**

¯

´

/

t

=

d¸

t

´

/

+ cd

t,t+1

÷(1 ÷)c,d:

t+1

+ cQ

¯

´

/

t+1

We can now rewrite part of this as:

¯

´c

t

= d:

t

+

¸

´c

d:c

t

+

:c

c

d¸

t

+ cd

t,t+1

÷(1 ÷)c,d:

t+1

+ c,

¯

´c

t+1

¯

´

/

t

=

d¸

t

´

/

+ cd

t,t+1

÷(1 ÷)c,d:

t+1

+ c,

¯

´

/

t+1

20

Now subtract the latter from the former:

¯

´c

t

÷

¯

´

/

t

= d:

t

+

¸

´c

d:c

t

+

:c

´c

d¸

t

÷

d¸

t

´

/

+ c,

_

¯

´c

t+1

÷

¯

´

/

t+1

_

Note that

j

bo

=

(1ço)

nc

and

nc

bo

=

1

b

b

**. Using these facts, we can write:
**

¯

´c

t

÷

¯

´

/

t

= ¯ :

t

+ (1 ÷c,) :c

t

+ c,

_

¯

´c

t+1

÷

¯

´

/

t+1

_

Now note that ¯ :

t

= (1 ÷c)

_

¯

´c

t

÷

¯

´

/

t

_

and

_

¯

´c

t+1

÷

¯

´

/

t+1

_

=

1te ¬

t+1

1ç

:

¯ :

t

= (1 ÷c)¯ :

t

+ (1 ÷c)(1 ÷c,) :c

t

+ c,1

t

¯ :

t+1

Now solve for ¯ :

t

:

c¯ :

t

= (1 ÷c)(1 ÷c,) :c

t

+ c,1

t

¯ :

t+1

¯ :

t

=

(1 ÷c)(1 ÷c,)

c

:c

t

+ ,1

t

¯ :

t+1

The above relationship is what is often called the New Keynesian Phillips Curve.

It is actually quite common to see the Phillips Curve expressed not in terms of the log-

deviation of real marginal cost, but rather in terms of an “output gap”. To get to that

speci…cation, let’s start with what de…nes real marginal cost and then go from there:

:c

t

=

n

t

c

t

We can substitute out for the wage using the household’s …rst order condition for labor

supply:

n

t

= c

o

t

o(1 ÷:

t

)

¸

Now use the accounting identity fact that consumption equals income to get:

:c

t

=

¸

o

t

o(1 ÷:

t

)

¸

c

t

Now let’s log-linearize this expression. Begin by taking logs:

ln :c

t

= o ln ¸

t

+ ln o ÷¸ ln(1 ÷:

t

) ÷ln c

t

Now do the …rst order Taylor series expansion about the steady state:

ln :c

+

d:c

t

:c

= ln :c

+ o

d¸

t

¸

+ ¸

d:

t

1 ÷:

÷

dc

t

c

:c

t

= o¯ ¸

t

+ ¸

:

1 ÷:

¯ :

t

÷¯c

t

21

Now, note that, from the aggregate production function, ¯ :

t

= ¯ ¸

t

÷¯c

t

:

:c

t

= o¯ ¸

t

+ ¸

:

1 ÷:

(¯ ¸

t

÷¯c

t

) ÷¯c

t

Simplifying:

:c

t

=

_

o + ¸

:

1 ÷:

_

¯ ¸

t

÷

_

1 + ¸

:

1 ÷:

_

¯c

t

The output gap is de…ned as the deviation between the actual level of output and the

“‡exible price” level of output, ¯ ¸

)

t

which is the level of output which would obtain in the

absence of price stickiness. If prices are not sticky, price is a constant markup over nominal

marginal cost, which implies that real marginal cost is constant, or equivalently that :c

t

= 0

(i.e. the log deviation of a constant is zero). We can then solve for the ‡exible price

equilibrium level of output in terms of the exogenous driving variable using this fact and the

above expression:

0 =

_

o + ¸

:

1 ÷:

_

¯ ¸

)

t

÷

_

1 + ¸

:

1 ÷:

_

¯c

t

¯ ¸

)

t

=

1 + ¸

a

1a

o + ¸

a

1a

¯c

t

Note that, if we have log utility over consumption (i.e. o = 1), then ¯ ¸

)

t

= ¯c

t

(i.e.

employment is constant in the ‡exible price equilibrium. Using the above, we can eliminate

¯c

t

from the expression for the log deviation of real marginal cost:

:c

t

=

_

o + ¸

:

1 ÷:

_

¯ ¸

t

÷

_

o + ¸

:

1 ÷:

_

¯ ¸

)

t

:c

t

=

_

o + ¸

:

1 ÷:

_

_

¯ ¸

t

÷ ¯ ¸

)

t

_

Letting i =

_

o + ¸

a

1a

_

, we can re-write the Phillips Curve in terms of the output gap

as:

¯ :

t

=

(1 ÷c)(1 ÷c,)

c

i

_

¯ ¸

t

÷ ¯ ¸

)

t

_

+ ,1

t

¯ :

t+1

Holding expected in‡ation …xed, we see that positive output gaps put upward pressure

on current in‡ation.

We can also log-linearize the rest of the model. Start with the Euler equation, after

having already imposed the accounting identity:

¸

o

t

= ,1

t

(¸

o

t+1

(1 + :

t

))

Take logs:

22

÷o ln ¸

t

= ln , ÷o ln ¸

t+1

+ :

t

Above I have imposed the approximation that ln(1 + :

t

) - :

t

. Now do the …rst order

Taylor series expansion:

÷o ln ¸

÷o

d¸

t

¸

= ln , ÷o ln ¸

+ :

÷o

d¸

t+1

¸

+ d:

t

De…ning ¯ ¸

t

=

ojt

j

and ¯ :

t

= d:

t

, we have:

÷o¯ ¸

t

= ÷o¯ ¸

t+1

+ ¯ :

t

¯ ¸

t

= ¯ ¸

t+1

÷

1

o

¯ :

t

The log-linearized Euler equation is often referred to as the “New Keynesian IS” curve,

as it shows a negative relationship between current spending and the current real interest

rate, holding …xed expected future spending.

Now let’s log-linearize the money supply curve (written in terms of real balances). It

can be written out as follows:

ln :

t

÷ln :

t1

+ :

t

= (1 ÷j

n

):

+ j

n

(ln :

t1

÷ln :

t2

) + j

n

:

t1

+ c

n

Since this equation is already in logs and already linear, we can write it exactly the same

way but interpreting the variables as log deviations ¯ :

t

=

ont

n

and ¯ :

t

= d:

t

:

¯ :

t

= (1 ÷j

n

):

+ ¯ :

t1

+ j

n

( ¯ :

t1

÷ ¯ :

t2

) ÷ ¯ :

t

+ j

n

¯ :

t1

+ c

n

Now let’s log-linearize the money demand function. First take logs:

ln · ÷· ln :

t

= ÷o ln ¸

t

+ ln i

t

÷ln(1 + i

t

)

Do the …rst order Taylor series expansion:

ln · ÷· ln :

÷·

d:

t

:

= ÷o ln ¸

+ ln i

÷ln(1 + i

) ÷o

d¸

t

¸

+

di

t

i

÷

di

t

1 + i

**Simplifying and use the tilde notation:
**

÷· ¯ :

t

= ÷o¯ ¸

t

+

_

1

i

÷

1

1 + i

_

¯

i

t

Simplifying further:

¯ :

t

=

o

·

¯ ¸

t

÷

_

1

·i

(1 + i

)

_

¯

i

t

Equilibrium requires that money demand be equal to money supply, so we can eliminate

money altogether from the set of equations by equating demand with supply:

23

o

·

¯ ¸

t

÷

_

1

·i

(1 + i

)

_

¯

i

t

= (1 ÷j

n

):

+ ¯ :

t1

+ j

n

( ¯ :

t1

÷ ¯ :

t2

) ÷ ¯ :

t

+ j

n

¯ :

t1

+ c

n

Simplify by solving for the current log deviation of output:

¯ ¸

t

=

_

1

oi

(1 + i

)

_

¯

i

t

+

·

o

(1 ÷j

n

):

+

·

o

¯ :

t1

+

·

o

j

n

( ¯ :

t1

÷ ¯ :

t2

) ÷

·

o

¯ :

t

+

·

o

j

n

¯ :

t1

+

·

o

c

n

We can write this in terms of the real interest rate by using the linearized Fisher rela-

tionship (

¯

i

t

= ¯ :

t

+ ¯ :

t+1

):

¯ ¸

t

=

_

1

oi

(1 + i

)

_

(¯ :

t

+ ¯ :

t+1

)+

·

o

(1÷j

n

):

+

·

o

¯ :

t1

+

·

o

j

n

( ¯ :

t1

÷¯ :

t2

)÷

·

o

¯ :

t

+

·

o

j

n

¯ :

t1

+

·

o

c

n

The expression above can be interpreted as an LM curve from intermediate macro – it

is the set of points in (¯ :

t

. ¯ ¸

t

) space consistent with the money market clearing. The IS

curve is the set (¯ :

t

. ¯ ¸

t

) pairs consistent with the “goods market” clearing, which means that

consumption is equal to income and the Euler equation holds. The IS equation is downward

sloping, while the LM curve is upward sloping.

Above we derived an expression for the ‡exible price equilibrium level of output as:

¯ ¸

)

t

=

1 + ¸

a

1a

o + ¸

a

1a

¯c

t

For notational ease, call ¸ =

1+¸

n

1n

o+¸

n

1n

, so:

¯ ¸

)

t

= ¸¯c

t

Now plug in this process for technology:

¯ ¸

)

t

= ¸j¯c

t1

+ ¸c

t

Now we know that ¯c

t1

=

1

¸

¯ ¸

)

t1

, so we can write this as:

¯ ¸

)

t

= j¯ ¸

)

t1

+ ¸c

t

The full set of log-linearized equations which allow us to solve the model are then:

¯ ¸

t

= ¯ ¸

t+1

÷

1

o

¯ :

t

(26)

¯ ¸

t

=

_

1

oi

(1 + i

)

_

(¯ :

t

+ ¯ :

t+1

)+

·

o

(1÷j

n

):

+

·

o

¯ :

t1

+

·

o

j

n

( ¯ :

t1

÷¯ :

t2

)÷

·

o

¯ :

t

+

·

o

j

n

¯ :

t1

+

·

o

c

n

(27)

24

¯ ¸

)

t

= j¯ ¸

)

t1

+ ¸c

t

(28)

¯ :

t

=

(1 ÷c)(1 ÷c,)

c

i

_

¯ ¸

t

÷ ¯ ¸

)

t

_

+ ,1

t

¯ :

t+1

(29)

Equation (26) is the IS curve, (27) is the LM curve, (28) is the process for the “supply

shock”, and (29) is the Phillips Curve. There are four equations and four variables (output,

real interest rate, the ‡exible price level of output, and in‡ation).

It turns out there is a graphical interpretation of this model that is is visually similar to

what one sees in intermediate macro. Holding the values of all future and past variables

…xed, as well as the value of current in‡ation, we can plot out the IS and LM curves as

follows:

Recall that the LM curve is drawn holding current in‡ation …xed (the IS curve does not

depend on current in‡ation). E¤ectively what this does is de…ne an equilibrium level of

output and the interest rate for each level of current in‡ation possible. If in‡ation goes up,

the LM curve shifts horizontally to the left (i.e. holding the real interest rate …xed output

must fall when in‡ation goes up). The opposite holds when in‡ation goes down. We can

then trace out an aggregate demand curve in (¯ :

t

. ¯ ¸

t

) space as follows:

25

When in‡ation is relative high, the LM curve is relatively far in, and so output is relatively

low, and vice versa. Tracing out the points, the AD curve is downward sloping. We

can complete the model by adding in the Phillips curve, which is an upward sloping AS

relationship, de…ned for a give value of the ‡exible price level of output and a given expected

future in‡ation:

26

Given this framework, we can graphically conduct comparative statics exercises. I should

be very upfront that this exercise is frought with hazards – there are lots of expected future

endogenous variables in these equations, all of which will, in general, move when exogenous

variables change. This means that shifting curves holding expectations of future endogenous

variables constant really isn’t correct. Nevertheless, if shocks are transitory enough, this

will provide a very good approximation.

Let’s …rst consider a monetary policy shock – this will cause the LM curve to shift right

(i.e. a positive innovation to c

n

raises output for a given interest rate).

27

The increase in money supply shifts the LM curve out – this raises the equilibrium level

of output for a given level of in‡ation, shifting the AD curve horizontally. In order to also

be on the Phillips Curve/AS relationship, in‡ation rises. This means that output rises by

less than the horizontal shift in the AD curve. The rise in in‡ation causes the LM curve

to shift back in some, so as to intersect the IS curve at the same level of output. We see

that, in equilibrium the real interest rate is lower, output is higher, and in‡ation is lower –

in other words, more or less exactly what our undergraduate intuition is. Furthermore, we

see that the increase in output due to monetary shocks is increasing in the ‡atness of the

Phillips Curve. When is the Phillips Curve ‡at? When c, the probability of not being

able to adjust one’s price, is big. In other words, money supply shocks have a bigger e¤ect

on output (and a smaller e¤ect on in‡ation), the stickier are prices. If prices are ‡exible,

so that c = 0, then the Phillips Curve is vertical at the ‡exible price level of output, which

means that monetary shocks have no real e¤ect and just lead to in‡ation.

Now let’s consider a “supply shock” – i.e. a shock to the ‡exible price level of output.

From inspection of the Phillips Curve, this leads to an outward shift of the AS relationship.

Graphically:

28

The outward shift in the AS relationship raises output and lowers in‡ation. The lower

in‡ation forces the LM curve outward. At the end of the day, the supply shock leads to

higher output, lower in‡ation, and a lower real interest rate. Note that the increase in output

is smaller than if the AS/Phillips Curve were perfectly vertical. This is what necessitates

the reduction in hours on impact in response to a technology shock in the model.

Finally, consider an “IS Shock”. We don’t formally have that in the model as speci…ed,

but would could think of it as a shock to expected future output. We will ignore the fact

that this would in‡uence expected in‡ation in equilibrium, which would in turn shift the

Phillips Curve:

29

Here the outward shift of the IS curve shifts the AD curve out, which raises both output

and in‡ation. The increase in in‡ation leads to the LM curve shifting back in some so as

to restore equilibrium. At the end of the day, output, in‡ation, and the real interest rate

are all higher.

The above exercise shows that this dynamic, optimizing model can be thought of in terms

very similar to what one learns in a typical intermdiate micro course. Of course, this is all

approximate. Nevertheless, it restores a lot of the Keynesian intuition.

30

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