Model appendix

Frank Smets and Raf Wouters

November 20, 2006

1 Decision problems of …rms and households and equilib-

rium conditions
1.1 Final goods producers
The …nal good Yt is a composite made of a continuum of intermediate goods Yt (i) as in
Kimball (1995). The …nal good producers buy intermediate goods on the market, pack-
age Yt , and resell it to consumers, investors and the government in a perfectly competitive
market.
The …nal good producers maximize pro…ts. Their problem is:

R1
maxYt ;Yt (i) Pt Yt 0 Pt (i)Yt (i)di
hR i
1
s:t: 0 G YYt (i) t
; p;t di = 1 ( f;t )

where Pt and Pt (i) are the price of the …nal and intermediate goods respectively,
and G is a strictly concave and increasing function characterised by G(1) = 1. pt is an
exogenous process that re‡ects shocks to the aggregator function that result in changes in
the elasticity of demand and therefore in the markup. We will constrain pt 2 (0; 1). pt
follows the exogenous ARMA process:
p p p p p
ln t = (1 p) ln + p ln t 1 p t 1 + t; p;t N (0; p) (1)
To simplify notiation, in what follows we leave out this argument.
The FOCs are:
Z 1
f;t Yt (i) Yt (i)
(@Yt ) Pt = G0 di
Yt 0 Yt Yt
Yt (i) 1
(@Yt (i)) Pt (i)= f;t G0
Yt Yt
resulting in
Z
Pt (i) 1 0 Yt (i) Yt (i)
0 1
Yt (i) = Yt G G di
Pt 0 Yt Yt
As in Kimball (1995), the assumptions on G() imply that the demand for input Yt (i)
is decreasing in its relative price, while the elasticity of demand is a positive function of
the relative price (or a negative function of the relative output).

1
1.2 Intermediate goods producers
Intermediate good producer i uses the following technology:

1
Yt (i) = "at Kts (i) t
Lt (i) t
(2)

where Kts (i) is capital services used in production, Lt (i) is aggregate labour input and
is a …xed cost. t respresents the labour-augmenting deterministic growth rate in the
economy and "at is total factor productivity and follows the process:

ln"at = (1 z )ln"
a
+ a
z ln"t 1 + a
t;
a
t N (0; a) (3)

The …rm’s pro…t is given by:

Pt (i)Yt (i) Wt Lt (i) Rtk Kt (i):

where Wt is the aggregate nominal wage rate and Rtk is the rental rate on capital.
Cost minimization yields the conditions:

(@Lt (i)) : (1 )t (1 )"at Kts (i) Lt (i) (4)

t (i) = Wt
(@Kts (i)) : t (i)
(1 )t "at Kts (i) 1 L (i)1
t = Rtk (5)

where t (i) is the Lagrange multiplier associated with the production function and equals
marginal cost M Ct .
Combining these FOCs and noting that the capital-labour ratio is equal across …rms
implies:
Wt
Kts = Lt (6)
1 Rtk
The marginal cost M Ct is the same for all …rms and equal to:

1
M Ct = (1 ) (1 )
Wt1 Rtk (1 )t
("at )

Under Calvo pricing with partial indexation, the optimal price set by the …rm that is
allowed to re-optimise results from the following optimisation problem:
1
X s h i
t+s Pt 1
max Et s
p Pet (i)( s p
l=1 t+l 1
p
) M Ct+s Yt+s (i)
Pet (i) s=0 t Pt+s

Pt (i)Xt;s
s:t: Yt+s (i) = Yt+s G0 1
t+s
Pt+s
where Pet (i) is the newly set price, p is the Calvo probability of being allowed to optimise

2
 s
Pt
one’s price, t is in‡ation de…ned as t = Pt =Pt 1 , [ t Pt+s
t+s
] is the nominal discount factor
for …rms (which equals the discount factor for the households that are the …nal owners of
R1
the …rms), t = 0 G0 YYt (i)t
Yt (i)
Yt di and
( )
1 f or s = 0
Xt;s = s p 1 p
( l=1 t+l 1 ) f or s = 1; :::; 1

The …rst-order condition is given by:

1
X s
t+s Pt 1 G0 (xt+s )
Et s
p Yt+s (i) Xt;s Pet (i) + Pet (i)Xt;s M Ct+s =0
t Pt+s G0 1 (zt+s ) G00 (xt+s )
s=0
(7)
where xt = G0 1 (zt ) and zt = PPt (i)
t
t.
The aggregate price index is in this case given by:

" 1
#
p p
0 1 Pt (i) t p 1 p 0 1 t 1 Pt 1 t
Pt = (1 p )Pt (i)G + p t 1 Pt 1G (8)
Pt Pt

1.3 Households
Household j chooses consumption Ct (j), hours worked Lt (j), bonds Bt (j), investment
It (j) and capital utilisation Zt (j), so as to maximise the following objective function:
1
X
s 1 1 c 1
Et (Ct+s (j) Ct+s 1)
c
exp 1+
Lt+s (j)1+ l
1 c l
s=0

subject to the budget constraint:

Bt+s (j)
Ct+s (j) + It+s (j) + b
Tt+s (9)
"t Rt+s Pt+s
h (j)L Rk Zt+s (j)Kt+s
Bt+s 1 (j) Wt+s t+s (j) 1 (j) Divt+s
+ + t+s a(Zt+s (j))Kt+s 1 (j) +
Pt+s Pt+s Pt+s Pt+s

and the capital accumulation equation:

It (j)
Kt (j) = (1 )t 1 (j) + "it 1 S It (j)
It 1 (j)
There is external habit formation captured by the parameter . The one-period bond
is expressed on a discount basis. "bt is an exogenous premium in the return to bonds, which
might re‡ect ine¢ ciencies in the …nancial sector leading to some premium on the deposit
rate versus the risk free rate set by the central bank, or a risk premium that households
require to hold the one period bond. "bt follows the stochastic process:

ln"bt = b
b ln "t 1 + b b
t; t N (0; b) (10)

3
 is the depreciation rate, S( ) is the adjustment cost function, with S( ) = 0;
S 0 ( ) = 0, S 00 ( ) > 0, and "it is a stochastic shock to the price of investment relative to
consumption goods and follows an exogenous process:

ln"it = i
i ln "t 1 + i i
t; t N (0; i) (11)

Tt+s are lump sum taxes or subsidies and Divt are the dividends distributed by the labour
unions.
Finally, households choose the utilitsation rate of capital. The amount of e¤ective
capital that households can rent to the …rms is:

Kts (j) = Zt (j)Kt 1 (j) (12)

The income from renting capital services is Rtk Zt (j)Kt 1 (j) , while the cost of changing
capital utilisation is Pt a(Zt (j))Kt 1 (j):
In equilibrium households will make the same choices for consumption, hours worked,
bonds, investment and capital utilization. The …rst-order conditions for consumption,
hours worked, bond holdings, investment, capital and capital utilisation can be written as
(dropping the j index):

c 1
(@Ct ) t = exp 1+
Lt (j)1+ l
(Ct Ct 1)
c
l

1 c 1 Wth
(@Lt ) (Ct hCt 1)
1 c
exp 1+
L1+
t
l
( c 1)Lt l = t
1 c l Pt

t+1
(@Bt ) t = "bt Rt Et
t+1

k i It
It It
(@It ) t = t "t 1 S( )) S0(
It 1
It 1 It 1
It+1 It+1 2
+ Et kt+1 "it+1 S 0 ( )( ) (13)
It It
" ! #
k
Rt+1
k k
(@ Kt ) t = Et t+1 Zt+1 a(Zt+1 ) + t+1 (1 ) (14)
Pt+1
Rtk
(@ut ) = a0 (Zt ) (15)
Pt

where t and kt are the Lagrange multipliers associated with the budget and capital
accumulation constraint respectively. Tobin’s is Qt = kt = t and equals one in the absence
of adjustment costs.

4
1.4 Intermediate labour union sector

Households supply their homogenous labour to an intermediate labour union which dif-
ferentiates the labour services and sets wages subject to a Calvo schemeiates about the
wage with the intermediate labour packers.

Before going into the household’s and the union’s decision on labour supply and wage
setting, more details on the labor market are needed. Labor used by the intermediate
goods producers Lt is a composite:
Z 1 1
1+ w;t

Lt = Lt (l) 1+ w;t dl : (16)

0

There are labor packers who buy the labor from the unions, package Lt , and resell
it to the intermediate goods producers. Labor packers maximize pro…ts in a perfectly
competitive environment. From the FOCs of the labor packers one obtains:
1+ w;t
Wt (l) w;t
Lt (l) = Lt (17)
Wt

Combining this condition with the zero pro…t condition one obtains an expression for the
wage cost for the intermediate goods producers:
Z 1 1 w;t

Wt = Wt (l) w;t dl (18)

0

We assume that w;t follows the exogenous ARMA process:

ln w;t = (1 w) ln w + w ln w;t 1 w w;t 1 + w;t ; w;t :: (19)

Labor packers buy the labour from the unions. The unions are an intermediate between
the households and the labor packers. The unions allocate and di¤erentiate the labour
services from the households and have market power: they can choose the wage subject
to the labour demand equation 17. The household’s budget constraint now also contains
the dividends of the union distributed to the households:
Bt+s (j)
Ct+s (j) + It+s (j) + 2 + At+s (j) Tt+s
bt Rt+s Pt+s
h (j)L k u
Bt+s 1 (j) Wt+s t+s (j) Divt+s Rt+s t+s (j)K t+s 1 (j)
+ + + a(ut+s (j))Kt+s 1 (j)
Pt+s Pt+s Pt+s Pt+s

The household labour supply decision is the same for all households and is given by the
following FOC:
h i
Wth 1
1
c
(Ct hCt 1)
1 c exp c 1
1+ l L1+
t
l
( c 1)Lt l
=
Pt t

5
 The real wage desired by the households here re‡ects the marginal rate of substitu-
tion between leisure and consumption. The marginal disutility of labour is equal accross
households and equal to:
0
Ul;t =
Labour unions take this marginal rate of substitution as the cost of the labour services
in their negotiations with the labour packers. The markup above the marginal disutility
is distributed to the households. However, the union is also subject to nominal rigidities
á la Calvo. Speci…cally, unions can readjust wages with probability 1 w in each period.
For those that cannot adjust wages, Wt (l) will increase at the determistic growth rate
and weighted average of the steady state in‡ation and of last period’s in‡ation ( t 1 ).
For those that can adjust, the problem is to choose a wage W~ t (l) that maximizes the wage
income in all states of nature where the union is stuck with that wage in the future:
1
X s h i
s t+s Pt h
max Et w[ ] Wt+s (l) Wt+s Lt+s (l)
ft (l)
W s=0 t Pt+s

1+ w;t+s
Wt+s (l) w;t+s
and Lt+s (l) = Lt+s
Wt+s
ft (l)( s
with Wt+s (l) = W w 1 w
) for s = 1; :::; 1
l=1 t+l 1

The …rst order condition becomes:

2
1
! 1+ w;t+s
1
X s
t+s Pt 6 ft (l)
Xt;s W w;t+s
s h
(@Wt ) 0 = Et w 4(Wt+s (l) Wt+s )
s=0 t Pt+s Wt+s

1+ w;t+s Xt;s
( )( )Lt+s Xt;s Lt+s (l)
w;t+s Wt+s
where ( )
1 f or s = 0
Xt;s = s w 1 w ) f or s = 1; :::; 1
( l=1 t+l 1
Simplifying by substituting for the individual labour and multiplying with the optimal
wage
1
X s
s t+s Pt ft (l) h 1+ w;t+s ft (l)Lt+s (l) = 0
Et w (Xt;s W Wt+s )( )Lt+s (l) Xt;s W
s=0 t Pt+s w;t+s

or
1
X s h i
s t+s Pt 1 h ft (l) = 0
Et w Lt+s (l) (1 + w;t+s )Wt+s Xt;s W (20)
s=0 t Pt+s w;t+s

The aggregate wage expression is

1 1
Wt = [(1 f
w )Wt
w;t
+ w(
w 1 w
Wt 1) w;t ] w;t
: (21)
t 1

6
1.5 Government Policies
The central bank follows a nominal interest rate rule by adjusting its instrument in re-
sponse to deviations of in‡ation and output from their respective target levels:
" #1 R
Rt Rt 1
R
t
1
Yt 2
Yt =Yt 1
3
= rt (22)
R R Yt Yt =Yt 1

where R is the steady state nominal rate (gross rate) and Yt is the natural output.
The parameter R determines the degree of interest rate smoothing. The monetary policy
shock rt is determined as

lnrt = r lnrt 1 + r;t (23)

The central bank supplies the money demanded by the household to support the de-
sired nominal interest rate.

The government budget constraint is of the form

Bt
Pt Gt + Bt 1 = Tt + (24)
Rt
where Tt are nominal lump-sum taxes (or subsidies) that also appear in household’s
budget constraint. Government spending expressed relative to the steady state output
path gt = Gt =(Y t ) follows the process:

lngt = (1 g )lng + g lngt 1 + ga lnZt ga lnZt 1 + g;t ; g;t ::: (25)

where we allow for a reaction of government spending to respond on the productivity

process. Or a slightly di¤erent speci…cation:

lngt ga lnZt = (1 g )lng + g (lngt 1 ga lnZt 1 ) + g;t ; g;t :::

1.6 The natural output level

The natural output level is de…ned as the output in the ‡exible price and wage economy.
The question is which shocks need to be taken into account. More in particular the
question is whether the markup shocks in prices and wages must be taken into account
in the calculation of the natural output level. If the markup shock are not taken into
account this will lead to a trade-o¤ problem between output-gap stabilisation and in‡ation
stabilisation. Persistent markup shocks might result in persistent con‡icts between the
two objectives and therefore in persistent deviations of in‡ation from the in‡ation target.

7
1.7 Resource constraints

To obtain the market clearing condition for the …nal goods market …rst integrate the
HH budget constraint across households, and combine it with the government budget
constraint:
Z Z Z
k
Pt Ct + Pt It + Pt Gt t + W t (j)Lt (j)dj + R t K t (j)dj P t a(u t ) Kt 1 (j)dj:

or in case of the labour unions:

Z Z Z
Pt Ct + Pt It + Pt Gt t+ Wth (j)Lt (j)dj + Divt + Rtk Kt (j)dj Pt a(ut ) Kt 1 (j)dj:

Next, realize that

Z Z
t = t (i)di = Pt (i)Yt (i)di Wt Lt Rtk Kt ;
R
where Lt = L(i)t di is total labor supplied by the labor packers (and demanded by
R R
the …rms), and Kt = Kt (i)di = Kt (j)dj. Now replace the de…ntion of t into the
HH budget constraint, realize that by the labor and goods’packers’zero pro…t condition
R R R
Wt Lt = Wt (j)Lt (j)dj, or = Wth (j)Lt (j)dj + Divt and Pt Yt = P (i)t Y (i)t di and
obtain:
Pt Ct + Pt It + Pt Gt + Pt a(ut )Kt 1 = Pt Yt ;

or
Ct + It + Gt + a(ut )Kt 1 = Yt (26)

where Yt is de…ned by eq(1) .

In the data we do observe Y t and Lt instead of Yt and Lt where

Z
Y t = Yt (i)di

Starting from eq (), the relationship between output and the aggregate inputs, labor
and capital, is:
Z 1+ p;t
Pt (i) p;t
Yt = Yt di
Pt
1+ p;t Z 1+ p;t

= Yt (Pt ) p;t Pt (i) p;t di

1+ p;t Z 1+ p;t

= Yt (Pt ) p;t Pt (i) p;t di

1+ p;t 1+ p;t
p;t
= Yt (Pt ) p;t Pt

8
 p;t
R 1+ p;t 1+ p;t
where P t = Pt (i) p;t di
and
Z
Lt = Lt (j)dj
Z 1+ w;t
Wt (j) w;t
= Lt dj
Wt
1+ w;t 1+ w;t
w;t
= Lt (Wt ) w;t Wt

w;t
R 1+ w;t 1+ w;t
where W t = Wt (j) w;t dj
In the …rst order approximation the barred concepts will equal the unbarred.

9
1.8 Exogenous Processes
There are seven exogenoues processes in the model:

Technology process:

lnZt = (1 z )lnZ + z lnZt 1 + z;t

Investment relative price process:

ln t = (1 )ln + ln t 1 + ;t

Intertemporal preference shifter (…nancial risk premium process):

lnbt = (1 b) ln b + b ln bt 1 + b;t

Government spending process:

lngt = (1 g )lng + g lngt 1 + ga lnZt ga lnZt 1 +

lngt ga lnZt = (1 g )lng + g (lngt 1 ga lnZt 1 ) + g;t

Monetary Policy Shock:

lnrt = r lnrt 1 + r;t

Price Mark-up shock:

ln p;t = (1 p) ln p + p ln p;t 1 p p;t 1 + p;t

Wage Mark-up shock: ln w;t = (1 w) ln w + w ln w;t 1 w w;t 1 + w;t

and where the innovations are distributed as i.i.d. Normal innovations:

i;t N (0; i)

2 Detrending and steady state

2.1 Intermediate goods producers
The model can be detrended with the deterministic trend and nominal variables can be
replaced by their real counterparts. Lower case variables represent detrended real variables
which can be considered as stationary processes that have a well de…ned steady state: for
instance
kt = Kt = t ; wt = Wt =(Pt t ); rtk = Rtk =Pt ; t = t c t

The aggregate production function 2 becomes

10
 yt (i) = Zt kt (i) (Lt (i))1 (27)

Equation 6 becomes:
wt
kt = Lt (28)
1 rtk
and at st.st.:
w
k = L
1 rk
The maginal cost expression ?? becomes:

M Ct wt1 rtk
mct = = (29)
Pt (1 )(1 )Z
t

Option 1: Expression ?? becomes

1
Pet (1 + p;t )M Ct Yt (i) +
p;t
X1 s
t+s Pt 1 1
Et s
p Pet (i)( s p
l=1 t+l 1
p
) (1 + p;t+s )M Ct+s Yt+s (i)
s=1 t Pt+s p;t+s

= 0

becomes:

1
(e
pt (1 + p;t )mct ) yt (i) +
p;t
1 1
!
X t+s 1 ( s p
l=1 t+l 1
p
)
s s (1 c )s
Et p pet (i) (1 + p;t+s )mct+s yt+s (i)
t p;t+s ( sl=1 t+l )
s=1
= 0

or
1
(e
pt (1 + p;t )mct ) yt (i) +
p;t
1 1
!
X 1 ( s p p
)
s s s t+s l=1 t+l 1
Et p pet (i) (1 + p;t+s )mct+s yt+s (i)
t p;t+s ( sl=1 t+l )
s=1
= 0 (30)
s
where pet = Pet =Pt ; = s c s and
t+s = t+s
c (t+s) is the real discount factor:

Note that in case c = 1 the expression simpli…es to the standard problem with as the
discount factor. This implies that in steady state:
(1 )
p~ = (1 + p) (1 ) w1 rk Z 1

Expression ?? becomes:
1 1 p;t
1 1
1 = (1 pt p;t +
p )~ p(
p
t 1
p
t ) p;t : (31)

11
which means that:
p~ = 1

Option 2: Equation (7)

1
X s
t+s Pt 1 G0 (xt+s ) 1 G0 (xt+s )
Et s
p[ ]Yt+s (i) 1+ Pet (i)Xt;s M Ct+s = 0
t Pt+s G0 1 (zt+s ) G00 (xt+s ) G0 1 (zt+s ) G00 (xt+s )
s=0

1
X
s s s t+s 1 G0 (xt+s ) pet (i)Xt;s 1 G0 (xt+s )
Et p yt+s (i) 1+ p mct+s = 0
t G0 1 (z 00
t+s ) G (xt+s ) Xt+s G0 1 (z 00
t+s ) G (xt+s )
s=0
(32)

where
p s
Xt+s = 0 for s = 0 or else ( l=0 t+l )

In steady state this gives (using G0 1 (G0 (1)) = x = 1)

1 G0 (1)
1 + [1 mc] = 0
G0 1 (G0 (1)) G00 (1)
G00 (1)
1+ 0 = mc
G (1)

The implied markup is equal to

G0 (1)
1 G00 (1) "(1)
mu(1) = G00 (1)
= G0 (1)
= = (1 + p)
1+ "(1) 1
G0 (1) G00 (1) + 1

G0 (1)
which corresponds with the elasticity of demand "(1) = G00 (1)

The aggregate price index in the case of the Calvo model becomes (8):

h i
0 1 1 1 1 1
1 = (1 p )pt (i)G [pt (i) ] + p
p t 1
p
t G0 1 p
t 1
p
t (33)

In steady-state1

1 = (1 p )p (i)G0 1
[p (i) ] + pG
0 1
[ ]
0 1
1 = p (i)G [z ]
1 = p (i)
1
Recall that zt = pt (i) t , hence z = p (i) and G0 1
(z ) = x = 1; = G0 (1) , G0 1
( ) = 1:

12
 Recall that aggregate pro…ts are equal to:

t = Pt Yt Wt Lt Rtk Kt :

In terms of detrended variables we then have, using 2 :

t
t
= yt wt Lt rtk kt
Pt
= Zt kt L1t wt Lt wt Lt
1
1
= Zt kt Lt wt Lt
1
wt
= (1 ) Zt wt (rtk ) Lt
1
h i wL
1 t t
= (1 )1 Zt wt (rtk ) 1
1
1 wt Lt
= 1
mct 1

At steady state we can use 1 = p (i) = (1 + p )mc to get st. st. pro…ts:

w L
= (1 + p 1)
1
w L
= p
1

2.2 Households
Expression ?? and ?? become:

c 1
t = b1t exp 1+
L1+
t
l
(ct (h= )ct 1)
c
(34)
l

1
t = b2t Rt Et [ t+1 t+1 ] (35)

respectively with where = ct and =( = c ) . At steady state:

t t

c 1
= b1 exp 1+
L 1+ l
c c
(1 (h= )) c
l

1
R =

Equation 12 and ?? become:

kt = ut kt 1= ; (36)
it
kt = [(1 )= ] kt 1 + t 1 S( ) it (37)
it 1

13
which deliver the steady state relationships:

k = u k = =k =
i = (1= ) (1 (1 )= ) k
= (1 (1 )= ) k

under the assumption that S( ) = 0; u = 1; and = 1:

The FOC with respect to investment, capital, and capital utilization are:
it it it
(@It ) 1 = Qkt t 1 S S0
it 1 it 1 it 1
( " #)
c t+1 2
t+1 it+1 it+1
+( = c
)Et ct
Qkt+1 t+1 S 0
t it it
c t+1 h i
c t+1 k
(@ Kt ) Qt = ( = )Et ct
(rt+1 ut+1 a(ut+1 )) + Qt+1 (1 )
t
(@ut ) rtk = a0 (ut )

with k= = Qt so that
t t

it it it
(@It ) 1 = Qkt t 1 S S0
it 1 it 1 it 1
( " #)
2
t+1 it+1 it+1
+( )Et Qkt+1 t+1 S
0
(38)
t it it
t+1 k
(@ Kt ) Qt = ( )Et [(rt+1 ut+1 a(ut+1 )) + Qt+1 (1 )] (39)
t
(@ut ) rtk = a0 (ut ) (40)

so that in steady state where Q = 1, u = 1; and a(u ) = 0:

1 = [(rk + (1 )]
In the variant for the utilisation cost, the accumulated utilisation costs becomes

a(ut+s (j)) (1 )
akt = 1 s
k t+s 1 (j) + akt 1

Option 1: Expressed in terms of detrended variables, equations ?? and 21 become:

1
" #
X 1
0
Ul;t+s (j) Xt;s f
s s
Et w t+s Lt+s (j) (1 + w;t+s ) + Wt (j) = 0
w;t+s t+s Pt+s
s=0
where
h i
0
Ul;t b1t 1
1
c
(Ct hCt 1)
1 c + `t exp c 1
1+ l L1+
t
l
( c 1)Lt l
=
c 1
t b1t exp 1+ l Lt (j)1+ l (Ct hCt 1) c

h i
1 1 l
1 c
(Ct hCt 1)
c + `
t ( c 1)Lt
=
(Ct hCt 1) c

= [(Ct hCt 1 )] Lt l

14
 for `t = 0:

1
" #
X 1 ( s w
l=0 t+l 1
1 w )
s s t+s
Et w ( t+s )Lt+s (j) [(ct (h= )ct 1 )] Lt
l
(1 + w;t+s ) + et (j) = 0
w
w;t+s ( sl=0 t+l 1 )
s=0

1
X
s s ss
1
Et w( = ) s( s t+s
t+s )Lt+s (j) [ [(ct (h= )ct 1 )] Lt
l
(1 + w;t+s )
s=0 w;t+s
#
( s w 1 w )
+ l=0s t+l 1 et (j) = 0
w
( l=0 t+l 1 )
1
" #
X s s 1 ( s w
l=0 t+l 1
1 w )
s
Et w ( ) ( t+s )Lt+s (j) [(ct (h= )ct 1 )] Lt
l
(1 + w;t+s ) + et (j) = 0
w
w;t+s ( sl=0 t+l 1 )
s=0
(41)

or option 2: from (20)

1
X s h i
s t+s Pt 1 h ft (l) = 0
Et w[ ]Lt+s (l) (1 + w;t+s )Wt+s Xt;s W
s=0 t Pt+s w;t+s

which becomes

1
" #
X t+s 1 ( s w
l=0 t+l 1
1 w )
s s s(1 c) h
Et w Lt+s (l) (1 + w;t+s )wt+s et (l) = 0
w
t w;t+s ( sl=0 t+l 1 )
s=0

1
" #
X s s t+s 1 ( s w
l=0 t+l 1
1 w )
s h
Et w Lt+s (l) (1 + w;t+s )wt+s et (l) = 0 (42)
w
t w;t+s ( sl=0 t+l 1 )
s=0

With 0
h
Ul;t l
wt+s = t
= [(ct (h= )ct 1 )] Lt
t
in steady state

(1 + w )wh = w
f
h
Ul;0
with w = = [(c (h= )c )] L l

= (1 h= )c L l

and where
1 1 w;t

Wt = (1 f
w )Wt
w;t
+ w(
w 1 w
Wt 1) w;t
t 1

becomes

1 1 w;t
1 1 1
wt = (1 et w;t +
w )w w(
w
t 1
w
t wt 1) w;t (43)

which imply at steady state:

h
w =w
~ = (1 + w )w

15
2.3 Resource constraints
The resource constraint(s) become:2

Ct + It + Gt + a(ut )Kt 1 = Yt

ct + it + y gt + a(ut )kt 1= = yt : (44)

and
y_ t = Zt kt L1t :

! 1+ p;t

P_t p;t
Yt = Y_ t
Pt
becomes 1+ p;t

yt = (p_t ) p;t y_ t
where
_ )t
(P
p_t =
Pt
P~t 1+ p;t _ )t
(P 1
1+ p;t p;t
1+ p;t
= [(1 p )( ) p;t + p( ) p;t ]
Pt Pt
1+ p;t 1+ p;t p;t
= [(1 p;t _ t 1 1+ p;t
p )~
pt + p( (p) ) ]
p;t
1 t

While
! 1+ w;t
_t
W w;t
Lt = _ t
(L)
Wt
becomes 1+ w;t
_ t
Lt = (w) w;t _ t
(L)
where
At steady state we have:
c +i +g y =y :
and
y = Z k L1 :
and
y_ = y ; L_ = L :

2.4 Government Policies

The Taylor rule becomes:
" #1 R
Rt Rt 1
R
t
1
yt 2
yt =yt 1
3
= rt (45)
R R yt yt =yt 1

2 Gt Gt
Using gt = Y t
, t = Y gt :

16
3 Steady state
Combining the steady state expressions:

From (28)
w
k = L :
1 rk
From (30)

(1 )
p~ = 1 = (1 + p) (1 ) w1 (rk ) Z 1

From (35)

1
R =

From (36) and (37):

k = k ;
i = (1 (1 )= ) k :

From (42):

h
w =w
~ = (1 + w )w

with
Ul;0
wh = = [(c (h= )c )] L l
= (1 h= )c L l

From (34):
c 1
= b1 exp 1+
L 1+ l
c c
(1 (h= )) c
l

From (39) and (40)

1 = ( )[(rk ) + (1 )]
1
rk = (1 )
1 c
= (1 )
and rk = a0 (u )

From (27):
y = Z k L1 :

From (44):
c i
+ +g =1
y y

17
 The ratio
wh L 1 w L
=
c 1+ w c
1 1 rk k
=
1+ w c
1 1 k y
= rk
1+ w y c
with
k y + L 1
= ( )
y y k
and
c i
= (1 g )
y y
i k
= (1 g )
k y

4 Log-linearized model
Eq. (29) becomes:
b t = (1
mc bt +
)w rbtk bt
Z (46)
Eq. (31) becomes:
b p
p~t = ( bt p bt 1 ) (47)
1 p

Option1:
Eq. (30) becomes:
e )
d(p (1 + p )d(mct ) mcd( p;t ) +
t
1 1
!
X ( s p p
)
s s s l=1 t+l 1
Et p d(e
pt ) + d( ) (1 + p )d(mct+s ) mcd( p;t+s )
( sl=1 t+l )
s=1
= 0

minus the same expression for time t+1 multiplied with p

1 e ) p e ))
d(p t (1 + p )d(mct ) mcd( p;t ) (d(p t+1
(1 p ) (1 p )
1 1 1
!
p p p p
p ( )
+ p d( t ) d( t+1 )
(1 p ) ( )2
= 0

in terms of deviations from steady state this becomes:

1 b b p b
p~t (1 + c t)
p )mc(mc mc p p;t p~t+1
(1 p ) (1 p )
p
+ ( p bt bt+1 )
(1 p )
= 0

18
 using 47 to substitute the optimal price expression

1 p b p p
( bt p bt 1 ) c t)
(mc mc p p;t ( bt+1 p bt )
(1 p )1 p (1 p )1 p

p (1 p)
+ ( p bt bt+1 )
(1 p ) (1 p)
= 0

regrouping

( bt p bt 1 ) p ( bt+1 p bt ) +( p ) ( p bt bt+1 )
(1 p )(1 p)
= c t + mc
(mc b
p p;t )
p

(1 + p) bt p bt 1 bt+1
(1 p )(1 p)
= c t + mc
(mc b
p p;t )
p

Finally we obtain:
(1 p )(1 p) p p
bt = b t+
mc bp;t + bt 1 + Et [bt+1 ] (48)
(1 + p ) p 1+ p 1+ p 1+ p

if c = 1; the expression = and the traditional expression is obtained again (see

also DSSW).

Option 2:
For the ‡exible price case the derivation is relative simple. Remember the presence
of the markup shock in the aggregtor function results in:3

G0 1 (z
t )G
00 (x )
t
d( ) d( p;t ) + d(pt (i)) d(mct ) = 0
G00 (xt ) G0 1 (z
t)
d(G0 1
(zt )) + d(G00 (xt )) d( p;t ) + d(pt (i)) d(mct ) = 0
G00 (xt ) 1 G0 1 (zt ) 000
d(z t ) + G d(xt) d( p;t ) + d(pt (i)) d(mct ) = 0
G00 (xt )
G00 (x) 1 G0 1 (z) 000
d(p t ) + G d(pt ) d( p;t ) + d(pt (i)) d(mct ) = 0
G00 (x) G00 (x)
G0 1 (z) 000
d(pt ) + 00 G d(pt ) d( p;t ) + d(pt (i)) d(mct ) = 0
G (x)
1
(2 + 00 G000 )pbt (i) mc d
p;t ct = 0
mcmc
G (x)
3 G000 (x)G0 1 (z) G000 (1)
The shock has been scaled with = G0 (1)
:

19
 where the deviations in the markup are exppressed in percentage of the marginal cost
h i
G00 (1)
1+ G0 (1)
pbt (i) = h ct + d
i (mc p;t )
G000
2+ G00 (1)

Linearization the aggregate price expression (33) (in stst: G0 1 [z] = x = 1 and =
G0 (1) and = 0)

b G0 (1)
0 = (1 p) pet (i) + 00 b pe (i)
G (1) t
G0 (1) G0 (1)
+ p p bt 1 bt + p 00 bt 1 bt
G (1) G00 (1)
0 = (1 p )bpe (i) + ( p bt 1 bt )
t p

b
pet (i) =
p
(bt p bt 1 )
1 p

Linearize the FOC for the Calvo wase with indexation (32):

1
X
s s s t+s 1 G0 (xt+s ) G00 (xt+s ) pet (i)Xt;s
Et p y t+s (i)( ) (1 + G0 1
(zt+s ) ) p mct+s = 0
t G0 1 (zt+s ) G00 (xt+s ) G0 (xt+s ) Xt+s
s=0
(49)

1
X
s s s t+s 1 G0 (xt+s ) pet (i)Xt;s G0 1 (z
t+s )G
00 (x
t+s ; p;t+s )
Et p y t+s (i)( ) p + mct+s = 0
t G0 1 (zt+s ) G00 (xt+s ) Xt+s
s=0
(50)

1
X
s s s Xt;s
Et p d(e
pt (i)) + d( p ) d(mct+s ) d( p;t+s )+ (51)
s=0
Xt+s
G000 G00 (x) 1
( d(xt+s ) + d(zt+s ))
G00 (x)
= 0

1
X
s s s Xt;s
Et p d(e
pt (i)) + d( p ) d(mct+s ) d( p;t+s ) (52)
s=0
Xt+s
G000 G00 (x)
+ 00
d(pt+s ) + d(pt+s ))
G G00
= 0

20
 1
X
s s s Xt;s G000
Et p d(e
pt (i)) + d( p ) d( p;t+s ) d(mct+s ) + d(pt+s ) + d(pt+s )) = 0
Xt+s G00
s=0

1
X
s s s G000 G000 Xt;s
Et p (2 + 00
)d(e
p t (i)) + (2 + 00
)d( p ) d(mct+s ) d( p;t+s ) =0
G G Xt+s
s=0

where
s p 1 p
Xt;s ( l=1 t+l 1 )
d( p ) = d( )
Xt+s ( sl=1 t+l )
p 1 1 p p 1 1 p

= p d( t ) + p d( t+1 ) + :::
p 1 p p 1 p
( ) ( )
d( t+1 ) d( t+2 ) :::
( )2 ( )2

minus the same equation for t+1 multiplied with p

G000 1 G000 p
0 = (2 + ) d(e
pt (i)) (2 + ) d(e
pt+1 (i)) d(mct ) d( p;t)
G00 1 p G00 1 p
1 1 1
!
p G000 p p
( p p
)
+ (2 + 00 ) p d( t ) d( t+1 )
(1 p ) G ( )2

G000 1 G000 G00

pebt (i) ped
p
0 = (2 + ) (2 + ) t+1 (i) (1 + ct + d
)(mc p;t )
G00 1 p G00 1 p G0
1 1 1
!
p G000 p p
( p p
)
+ (2 + ) p bt bt+1
(1 p ) G00 ( )2

using the expression for b

pet (i)

1 p p p
0 = ( ( bt p b t 1 )) ( bt+1 p bt )
1 p 1 p 1 p 1 p
!
G00 p 1 1 p p 1 p
(1 + G0 ) p ( )
G000
ct
(mc +d
p;t ) + p bt bt+1
(2 + G00 ) (1 p ) ( )2

p
0 = (( bt p b t 1 )) ( bt+1 p bt )
1
p (1 p)
+ ( p bt bt+1 )
p
G00 (1 )(1
(1 + G0 ) p p)
G000
ct + d
(mc p;t )
(2 + G00 ) p

21
 0 = bt p bt 1 p bt+1 + p p bt

+ ( p bt bt+1 ) p ( p bt bt+1 )
G00
(1 + ) (1 p )(1 p)
G0
G000
ct + d
(mc p;t )
(2 + G00 ) p

(1 p )(1 p)
(1 + p) bt = p bt 1 + bt+1 + A ct + d
(mc p;t ) (53)
p
G00
(1 + G0 )
with A = G000
(2 + G00 )

If we consider the special case in which the aggregator function G reduces to the Dixit-
Stiglitz aggregator, we can see that option 1 and option 2 results in the same NKPC: in that
case G(x) = (x)1=(1+ ) and A = 1. The following relation between A and the curvature
holds:
G00
(1 + G0 ) 1 1
A = G000
= =
(2 + G00 )
+1 " 1 +1
G00
d(") d( xG 0) G000
= = = 1 + " + " 00
d(x) d(x) G

Eq. 28 becomes:
b bt
kt = w bt :
rbtk + L (54)

Eq. 34 becomes:

(1 h= )bt = (1 h= )bb1 t cb
ct + c (h= )b
ct 1 + (1 h= )( c
bt
1)L1+ l L

Ul;0
using wh = = [(ct (h= )ct 1 )] Lt
l
:

(1 h= )bt = (1 h= )bb1 t cb
ct + c (h= )b
ct 1 +( c
bt
1)(wh L=c )L (55)

h
[ wc L = 1+
1
w
1
rk ky y
c ]

Eq. 35 becomes:
b = bb2 + R
bt + Et [bt+1 ] Et [bt+1 ]: (56)
t t

Eq. 36 becomes:
b bt + b
kt = u kt 1:

Eq. 37 becomes:
b i b i i b
k t = (1 ) kt 1 + t + it : (57)
k k k

22
Eq. 38 becomes:

it it it
Qkt t 1 S S0
it 1 it 1 it 1
( )
2
t+1 it+1 it+1
+ Et [Qkt+1 t+1 S 0 ] =1
t it it

becomes:

b k + bt
Q 2 00b
S it + 2 00b
S it 1 +( ) 2 00b
S it+1 ( ) 2 00b
S it =0
t

bit = 1 1 b kt + 1
(bit 1 +( )bit+1 + 2 S 00
Q 2 S 00
bt (58)
(1 + )
Eq. 39 becomes:

bk = rk k (1 )
Qt t + Et [ t+1 ] + Et [rt+1 ]+ Et [Qkt+1 ]: (59)
rk + (1 ) rk + (1 )

where the steady state expression (rk + (1 )) = 1 is used.

Eq. 40 becomes:
rk rbtk = a00 u
bt : (60)

or in case of accumulated costs (assuming s = 0) expressed relative to output:

a0 (u )k 1
akt = ubt + akt 1

1
= rk k ubt + akt 1

Option 2 for wage setting:

Eq. 42 becomes:

h c e
w bet + w e
w bet+1
(1 + w )w bth +
w ww
h
w; t w w
(1 w ) (1 w )
w e
w w e
w
w bt + bt+1
(1 w ) (1 w )
= 0

Using Eq. 43:

1 w w w w b~ t :
bt
w bt
w 1 + bt bt 1 =w
1 w 1 w 1 w 1 w

and

1 h= b
bth =
w b
ct b
ct 1 + l Lt
1 h= 1 h=
results in

23
 (1 + w )w
h
bth +
w ww
h c
w; ew
w bt + w
ewbt
t
e
w 1
bt
[w w bt
w 1 + w bt w w bt 1]
(1 w ) (1 w)

w e
w 1
+ bt+1
[w w bt +
w w bt+1 w w bt ]
(1 w ) (1 w)

w e
w (1 w) w e
w (1 w)
w bt + bt+1
(1 w ) (1 w) (1 w ) (1 w)
= 0

w c
(1 w )(1 w) bth +
w w; t bt
w
(1 + w)
+(1 w w + w bt
w )w

bt
[w w bt
w 1 + w bt w w bt 1]

+ w bt+1
[w w bt +
w w bt+1 w w bt ]

w w (1 w )b t + w (1 w )b t+1

= 0

(1 + bt
)w bt
w 1 bt+1
w (61)
(1 w )(1 w) w c
= bth +
[w w; t bt ]
w
w (1 + w)
(1 + w )b t + w bt 1 + bt+1

Eq. (44) becomes:

c i b rk k
ybt = gbt + b
ct + it + bt :
u (62)
y y y

Eq. (27) becomes (remember ybt = b

y_ t ):

y + b y + bt + y + bt
ybt = kt + (1 ) L Z (63)
y y y

Eq. (45) becomes:

bt
R = b
R Rt 1 + (1 R )( 1 b t + 2 (b
yt ybtf lex ))
f lex
+ ybt b f lex
ybt 1 )) + rt
3 (b
yt 1 (y t (64)

24
5 Estimated equations and rescaling residuals
5.1 For the sticky economy

Eq. (46):
b t = (1
mc bt +
)w rbtk bt
Z

Eq (53)

(1 p )(1 p)
(1 + p) bt = p bt 1 + Et [bt+1 ] + A c t) + d
(mc p;t
p

Eq (61)

(1 + bt
)w bt
w 1 bt+1 ]
Et [w
(1 w )(1 w) 1 h= b
= [ b
ct b
ct 1 + l Lt bt ]
w
w 1 h= 1h=
(1 + w )b t + w bt 1 + Et [bt+1 ] + cw; t

Eq (56)

b
ct
1 (h= )
= Et [b
ct+1 ] + b
ct 1
(1 + (h= )) (1 + (h= ))
(1 h= ) b2 b
(bt + Rt Et [bt+1 ])
c (1 + (h= ))
( c 1)(wh L=c ) h i
(Et Lb t+1 b t ):
L
c (1 + (h= ))

Eq (54)
b bt
kt = w bt :
rbtk + L

Eq (60)
rk rbtk = a00 u
bt :

Eq (57)

b i b i i b
k t = (1 ) kt 1 + t + it :
k k k

Eq (58)
1 h i 1 1
bit = (bit 1+( )Et bit+1 + b kt +
Q bt
2 S 00 2 S 00
(1 + )

25
 Eq (59)

b k = bb2 bt rk k (1 )
Q t t (R Et [bt+1 ]) + Et [rt+1 ]+ Et [Qkt+1 ]:
rk + (1 ) rk + (1 )

Eq. (64):

bt
R = b
R Rt 1 + (1 R )( 1 b t + 2 (b
yt ybtf lex ))
f lex
+ ybt b ybtf lex
3 (b
yt 1 (y t 1 )) + rt

Eq. (63):
y + b y + bt + y + bt
ybt = kt + (1 ) L Z
y y y
Eq. (62):

c i b rk k
ybt = gbt + b
ct + it + bt :
u
y y y

5.2 For the ‡exible economy

26