Chapter 8 : New Keynesian Monetary Economics

In the 1970s, 1980s, and early 1990s, models used for monetary policy analysis combined the assumption of nominal rigidity with a simple structure that linked the quantity of money to aggregate spending. While the theoretical foundations of these models were weak, the approach proved remarkably useful in addressing a wide range of monetary policy topics.1 Today, the standard approach in monetary economics and monetary policy analysis incorporates nominal wage and/or price rigidity into a dynamic, stochastic, general equilibrium (DSGE) framework that is based on optimizing behavior by the agents in the model. These modern DSGE models with nominal frictions are commonly labelled “new Keynesian”models because, like older versions of models in the Keynesian tradition, aggregate demand plays a central role in determining output in the short run and there is a presumption that some ‡uctuations both can be and should be dampened by countercylical monetary and/or …scal policy.2 Early examples of models with these properties include those of Yun (1996), Goodfriend and King (1997), Rotemberg and Woodford (1995, 1997), and McCallum and Nelson (1999). Galí (2002) discusses the derivation of the model’s equilibrium conditions, and book length treatments of the new Keynesian model are provided by Woodford (2003) and Galí (2008). The …rst section of this chapter shows how a basic money-in-the-utility function (MIU) model, combined with the assumption of monopolistically competitive goods markets and price stickiness, can form the basis for a simple linear new Keynesian model.3 The model is a consistent general equilibrium model in which all agents face well-de…ned decision problems and behave optimally, given the environment in which they …nd themselves. To obtain a canonical new Keynesian model, three key modi…cations will be made to theMIU model of chapter