Three Equations model and Dynamic Analysis

22-04-2020
Consider the following model which we have derived while solving utility

maximization and profit maximization problems. All variables, except rate of

interest, are expressed in natural logarithmic form.

(1.1)

(1.2)

(1.3)

, ,
Equation (1.1) is an IS equation, equation (1.2) is the equation of Phillips curve, and

equation (1.3) is the Taylor rule.

1-Model solution

1.1 Monetary Innovation Shock

Simple model

Our baseline model involve no government ( ) and no productivity shock (

). We first solve this model to study the impact of monetary innovation shock

( ) and assume that all other shocks take their mean values i.e., . Our

simple model is as follows:

1
 (3)
Substituting (3) into (1) we get:

(4)

After this substitution, our model now comprises of just two equations i.e., equation

(2) and (4) and we left with two endogenous variables namely and . To solve

this model analytically, we use the method of undetermined coefficients, and

assume the following trial solution:

i i
y t =a ut , π t =c u t (5)

We also assume that follows an AR(1) process as given by (6):

(6)

Using (5) and (6) we can easily show that and .The final

solution is derived by substituting the trial solution into equations (2) and (4) and

using (6) we get the following set of restrictions on parameters a and c :

(7)

(8)

2
Writing the above system in matrix-form:

Using (5) and (9) we can derive the following multipliers:

(10)

(11)

Using (3), (10), and (11) we get

(12)

From (10), (11), and (12) we note that a monetary innovation shock causes a decrease

in output, decrease in inflation, but impact on nominal rate of interest is ambiguous.

1.2 Price Puzzle

When an increase (a decrease) in the interest rate causes increase (a decrease) in

inflation is called price puzzle. From (12) we may note that if

our model predicts a price puzzle.

1.3 Government Spending Shock

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To study the implications of change in government spending on output, inflation,

and interest rate, we assume that is a random variable and follows an AR(1)

process:

(13)

To solve this model analytically, we assume that for

convenience, and also assume the following trial solution:

(14)
The final solution is derived by substituting the trial solution into equations (2) and

(4) and using (13) and (14) we get the following set of restrictions on parameters a

and c :

(15)

(16)
To apply Cramer’s rule on (15) and (16) we first write the model in form:

(17)
From (17) we can derive the following multipliers:

(18)

(19)

Using (3), (18), and (19) we get

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 (20)

Quiz: Does an increase in government spending also increases hours-worked?

To answer this question, we should recall our input output relationship:

(21)
The log-linearization of (21) gives:

(22)

From (22) we can show that:

(23)

Quiz: Re-derive the above multipliers by assuming >0

Quiz: Determine the impact of improvement in the productivity ( ) on equilibrium

output, inflation, interest rate, and hours worked when follows the following

AR(1) process:

(24)

1.4 Divine Coincidence

Blanchard and Gali (2006) have shown that in case of perfect wage flexibility, the

standard new-Keynesian model suffers from divine coincidence, which is defined as

5
stabilizing inflation is equivalent to stabilizing the output gap. In other words, if

because of a shock, (for example, positive demand shock) both inflation and output

increases and if central bank try to control, for example, the inflation rate, then

output gap will also be corrected automatically without any extra effort. Blanchard

and Gali (2006) called this property of new-Keynesian model as “divine

coincidence”. This divine coincidence is not a desirable property of the model, since

in real world most of the central bank do observe a trade-off between inflation and

output gap.

To understand the divine coincidence phenomenon, consider the following

closed economy standard neo-Keynesian macro model:

(25)

(26)

(27)

Where
Note that we augmented the Taylor rule with the inclusion of demand-side shock i.e.

. According to this Taylor rule, central bank tends to increase the interest rate to

offset the impact on output of a positive demand-side shock. To solve the above

model, we assume the following trial solution, while assuming is a pure random

shock:

(27)
Following the above procedure, we may derive the following multipliers:

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 (28)

(29)

(30)

From (28), we note that in order to defuse the pressure of the shock on output,

central bank may set . In this case, we can note that . It is interesting

to note that under the same condition i.e., , inflation is automatically

controlled i.e., (see equation 29). This is an example of divine coincidence.

One more thing we may note here is that under the same condition (what

does it mean?)

Quiz: Divine coincidence occur only in case of demand side-shock but not in the

case supply-side shock. True/false? Use some model to answer this question.