In the 1970s,1980s and early 1990s, model used for monetary policy analysis combined the assumption of nominal rigidity with simple structure that linked the quantity of money to aggregate spending. Although the theoretical foundations of these models were weak, the approach proved remarkably useful in addressing a wide range of monetary policy topics.Today, the standard approach in monetary economics and monetary policy analysis incorporates nominal wage or price rigidity into a dynamic stochastic general equilibrium framework that is based on optimizing behavior by the agents in the model.
These modern DSGE models with nominal frictions are commonly labeled 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 fluctuations both can be and should be dampened by countercylical monetary or fiscal policy.
Firstly,we think how a basic money-in-the-utility function model , combined with the assumotion of monopolistically competitive goods markets and price stickness, can form the basis for a simple linear new Keynesian models. The model is a consistent general equilibrium model in which all agents face well-defined decision problems and behave optimally, given the environment in which they find themselves. To obtain a canonical new Keynesian model, three key modifications will be made to the normal MIU model. Next,endogeous variations in the capital stock are ignored. Endogenous capital stock dynamics play a key role in equilibrium business cycle models in the real business cycle tradition, but the response of investment and the capital stock to productivity shocks actually contributes little to the dynamics implied by such models. For simplicity, then, the capital stock will be ignored.
Second, the single final good in the MIU model is replaced by a continuum of differentiated goods produced by monopolistically competitive firms. these firms face constraints on their ability to adjust prices, thus introducing nominal price stickiness into the model.
Lastly,monetary policy is represented by a rule for setting the nominal rate of interest. Most central banks today use a short-term nominal interest rate as their instrument for implementing monetary policy. The nominal quantity of money is then endogenously determined to achieve the desired nominal interest rate. Important issues are involved in choosing between money supply policy procedures and interest rate procedures.
These three modifications yield a new Keynesian framework that is consistent with optimizing behavior by private agents and incorporates nominal rigidities yet is simple enough to use for exploring a number of policy issues. It can be linked directly to the more traditional aggregate supply -demand model that long served as one of the workhorses for monetary policy analysis and is still common in most undergraduate texts.
- Monetary Theory and Policy/The MIT Press
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