The Basic New Keynesian Model Explained

The Basic New Keynesian Model
Josef Strsk
josef.strasky@gmail.com
12th May 2011
Josef Strsk
Todays program:
Basic New Keynesian model

Calvo pricing
Equilibrium under an Exogenous Money Supply
Effect of Monetary Policy Shock
Effect of Technology Shock
Josef Strsk
New Keynesian Model
Basic assumptions:
imperfect competition in the goods market
differentiated goods (continuum of differentiated goods)
producer sets the price
constraints on the price adjustment (Calvo pricing)
effects of monetary policy shocks and technology shocks
Josef Strsk
Households I
Objective function:
E0
t U(Ct , Nt )
(1)
t=0
Nt - hours of work
U(Ct , Nt ) - utility function, increasing in Ct , decreasing in
Nt and concave with respect to both variables
Ct - consumption index
Ct =
1 1
Ct (i)
di
(2)
We assume existence of continuum of goods represented by

the interval [0, 1].
Ct (i) - quantity of goods i consumed by the household in period
t.
Josef Strsk
Households II
Households must decide how to allocate expenditure among
different goods for any level of expenditures
R1
Zt = 0 Pt (i)Ct (i)di.
L=
1 1
Ct (i)
di
! 1
Pt (i)Ct (i)di Zt
Let us compute:
d
dCt (i)
Z 1
0
Ct (i)
1 1
di
Z 1
0
= Ct Ct (i)
Ct (i)
1 1
di
1

1
1
1
Ct (i)
We used definition (2)

Ct =
1 1
Ct (i)
di
! 1
(3)
We have therefore F.O.C. for all i:

1
Ct Ct (i) = Pt (i)
Josef Strsk
(4)
Households III
Recall:
1
Ct Ct (i) = Pt (i)
(5)
Therefore:
Ct (i) = Ct (j)
Pt (i)
Pt (j)
(6)
Compute:
Ct (i)Pt (i) = Ct (j)Pt (j)
Zt =
Z 1
0
Ct (i)Pt (i) = Ct (j)Pt (j) Pt (i)

Z 1
1
1
Pt (i)Ct (i)di = Ct (j)Pt (j)
Pt (i)
di = Ct (j)Pt (j) Pt
0
We introduced price index Pt :

Z
Pt =
1
1
Pt (i)
Pt1 =
di
1
! 1
Pt (i)1 di
Josef Strsk
(7)
Recall:
Ct (i) = Ct (j)
Pt (i)
Pt (j)
Zt = Ct (j)Pt (j) Pt1

It clearly follows that:
Ct (i) =
Pt (i)
Pt
Zt
Pt
Recall definition (2) and substitute:

Ct =
Z 1
0
e1
Ct (i) di
1
1
Pt
Zt Pt
Pt
Zt Pt
Z 1
0
Pt (i)
diPt
Zt Pt
= Zt Pt
And therefore we have:

Zt =
Pt (i)Ct (i)di = Pt Ct
Josef Strsk
(8)
Households V
Recall:
Ct (i) =
Pt (i)
Pt
Zt = Pt Ct
Zt
Pt
We finally got the households demand schedule:

Ct (i) =
Josef Strsk
Pt (i)
Pt
Ct
Households VI
Budget constraint:
Z 1
Pt (i)Ct (i)di + Qt Bt Bt1 + Wt Nt Tt
(9)
Pt Ct + Qt Bt Bt1 + Wt Nt Tt
(10)
Ct (i) - consumption of good i

Pt (i) - price of good i
Ct - consumption index
Pt - price index
Wt - nominal wage
Tt - net taxation expressed in nominal terms
Bt - quantity of one-period bonds, purchased in period t
Qt - price of a bond
Each bond purchased in t matures in t + 1 and pays one unit of
money.
Josef Strsk
Households VII
i) Intratemporal substitution Optimal households plan
conditions
Uc,t dCt = Un,t dNt
(11)
Pt dCt = Wt dNt
(12)
Intratemporal substitution condition:
Un,t
Wt
=
Uc,t
Pt
(13)
i) Intertemporal substitution
Uc,t dCt = Et (Uc,t+1 )dCt+1
Pt dCt = Qt Pt+1 dCt+1
Intertemporal substitution condition:

Uc,t+1 Pt
Qt = Et
Uc,t Pt+1
Josef Strsk
(14)
(15)
(16)
Households IV
Let us assume simple separable utility function:
Ct1
N 1+
t
1 1+
Uc,t (Ct ) = Ct
U(Ct , Nt ) =
Un,t (Nt ) =
Nt
(17)
(18)
(19)
We plug the utility function into optimality conditions:

Wt
= Ct Nt
Pt

Ct Pt
Qt = Et
Ct+1
Pt+1
(20)
(21)
The first condition can be exactly log-linearised:

wt pt = ct + nt
Josef Strsk
(22)
Log-linearization of second condition I

Recall:
Qt = Et

Ct
Ct+1
Pt
Pt+1
(23)
Let us define:
it = log Qt - nominal interest rate (logarithm of gross
yield of bond)
= log - households discount rate
t+1 = log
Pt+1
Pt
- inflation rate
ct+1 = ct+1 ct = log
Ct+1
Ct
- growth
The optimality condition can be now equivalently rewritten as:

1 = Et (exp (it ct+1 t+1 ))
Josef Strsk
(24)
Log-linearization of second condition II

Recall:
1 = Et (exp (it ct+1 t+1 ))
(25)
For perfect foresight steady state, we assume constant inflation

and constant growth . We therefore have following steady
state condition:
i = + +
(26)
Now we can log-linearize the condition:

exp(it ct+1 t+1 )
1 + (it i) (ct+1 ) (t+1 )
1 + it ct+1 t+1
We can now derive log-linearized Euler equation:
1 = Et (1 + it ct+1 t+1 )
1
ct = Et (ct+1 ) (it Et (t+1 ) )
Josef Strsk
(27)
Firms I
Production function:
Yt (i) = At Nt (i)1
(28)
All firms face identical stochastic demand schedule:

Pt (i)
Ct (i) =
Ct
Pt
Firms take aggregate price level Pt and aggregate consumption
index Ct as given.
Josef Strsk
Calvo pricing
Introduction of price stickiness as proposed by Calvo (1983).
Each firm can reset its price with probability (1 ) in
any given period independently of the time elapsed since
the last adjustment.
Consequently, in each period (1 ) fraction of firms reset
their prices, whereas firms cannot change the price in
this period.
is natural index of price stickiness
Average duration of a price is (1 )1
All firms that are allowed to reset the price in the period
face the same optimality problem. Therefore they all
choose new optimal price P t
Let us employ following strategy:
1
Let us first investigate Aggregate price dynamics as if we
know new optimal prices Pt
2
Afterwards we investigate Optimal price settings by firms
Josef Strsk
Aggregate price dynamics I

Price index in any given period can be written as:
Pt =
Pt1 (i)1 di + (1 )(Pt )1
1
! 1
1
1

1
Pt = Pt1
+ (1 )(Pt )1
1
Pt1 = Pt1
+ (1 )(Pt )1
Pt1
1
Pt1
t1
(Pt )1
1
Pt1
1
Pt
= + (1 )
Pt1
= + (1 )
=
We obviously used 1
t
Pt
Pt1
Josef Strsk
1
Aggregate price dynamics II
Recall:
t1 = + (1 )
Pt
Pt1
1
Now let us log-linearize this condition around steady state with

zero inflation: Pt = Pt1 = Pt = P and t = 1.

log e(1) log t = log + (1 )e(1)(log Pt log Pt )
(1 )t = (1 )(1 )(pt p) (1 )(1 )(pt p)

t = (1 )(pt pt )
Josef Strsk
Optimal price settings I

Any firm reoptimizing in period t chooses such price Pt that
maximizes the current market value of the profits generated
until the price remains effective:
max
Pt
k =0

k Et Qt,t+k Pt Yt+k |t t+k (Yt+k |t )
Yt+k |t - product in period t + k of a firm that last

reoptimized in t
Psi() - costfunction

C
Pt
Qt,t+k = k Ct+k
Pt+k - stochastic discount factor for
t
nominal payoffs
Reoptimizing firm is subject to the sequence of demand
constraints for all k:

Pt
Ct+k
Yt+k |t =
Pt+k
Josef Strsk
(29)
Optimal price settings II

Recall the optimality problem, substitute the constraint,
differentiate by Pt and compute:
max
Pt
max
Pt
X
k =0
k =0
k =0

k Et Qt,t+k Pt Yt+k |t t+k (Yt+k |t )
"
k Et Qt,t+k
k
Pt
Pt
Pt+k
Ct+k t+k
"
(1 )Yt+k |t + t+k |t Yt+k |t
"
Yt+k |t +
Et Qt,t+k
Pt
Pt+k
Ct+k
(1)
Pt
Ct+k
Pt+k
!#
(1) Ct+k
t+k |t (Yt+k |t ) Pt
1
Pt+k
k =0

k Et Qt,t+k Yt+k |t Pt +
t+k |t (Yt+k |t ) Yt+k |t
=0
1
k
Et Qt,t+k
k =0
X
k =0

k Et Qt,t+k Yt+k |t Pt + M t+k |t (Yt+k |t ) = 0
Josef Strsk
!!#
!#
=0
=0
Optimal price settings III

Recall:
X
k =0

k Et Qt,t+k Yt+k |t Pt + M t+k |t (Yt+k |t ) = 0
t+k |t = dt+k (Yt+k |t )/dYt+k |t - nominal marginal costs

M=
Note that for limit case of no price rigidities ( = 0):

Pt = Mt|t
(30)
M can then be interpreted as desired (frictionless) markup (if firms

may change price in any period the would always choose such
markup).
We can further rewrite optimality condition:

X
Pt+k
Pt
k
+ M MCt+k |t (Yt+k |t )
=0
Et Qt,t+k Yt+k |t
Pt1
Pt1
k =0
where MCn+k |t =
t +k |t
Pt +k
are real marginal costs.

Josef Strsk
Optimal price settings IV

Recall:
X
k =0

Pt+k
Pt
+ M MCt+k |t (Yt+k |t )
=0
k Et Qt,t+k Yt+k |t
Pt1
Pt1
Let us log-linearize this condition around zero inflation:

Pt
Pt+k
Pt1 = Pt1 = 1. This implies that all firms will produce the
same quantity of output: Yt+k |t = Y and MCt+k |t = MC. In
constant price environment, there is no effect of price rigidities
1
and therefore MC = M
. Finally in steady states Qt+k |t = k
holds.
X
k =0

t+k |t + pt+k pt1 ) = 0
()k pt pt1 + Et (mc
pt pt1 = (1 )
t+k |t + pt+k pt1 )

()k Et (mc
k =0
pt = + (1 )
()k Et (mct+k |t + pt+k )
k =0
Josef Strsk
Goods Market Equilibrium

Equilibrium condition:
Yt (i) = Ct (i)
(31)
We define aggregate output similarly to consumption index:

Yt =
Yt (i)
e1
di
(32)
Therefore:
Yt = Ct
(33)
From intertemporal optimality condition and equilibrium

condition:
yt = Et (yt+1 )
1
(it Et (t+1 ) )
Josef Strsk
(34)
Labour Market Equilibrium

Clearing of labour market requires:
Z 1
Nt (i)di
Nt =
0
1
Yt (i) 1
Nt =
di
At
0

1 Z 1
Yt 1
Pt (i) 1
Nt =
di
At
Pt
0
Z
1
Second row follows directly from production function and the

third one employs consumption schedule with Yt Ct .
In log terms (exactly):
(1 )nt = yt at + dt
(35)

1
R1
di is price dispersion. It
where dt = (1 ) log 0 PPt (i)
t
might be found out that dt var (pt (i)), which is equal to zero in
the first order approximation around zero inflation steady state
Josef Strsk
(see Gali - Chapter 3, Appendix).
Marginal Costs
Economys average real marginal costs:
mct = (wt pt ) mpnt
mct = (wt pt ) (at nt ) log(1 )
1
(at yt ) log(1 )
mct = (wt pt )
1
(We used twice production function); Similarly:
mct+k |t = (wt+k pt+k ) mpnt+k |t
1
mct+k |t = (wt+k pt+k )
(at+k yt+k |t ) log(1 )
1
Put together:
(yt+k |t yt+k )
1
(p pt+k )
mct+k |t = mct+k
1 t

Pt
Second row follows from demand schedule: Yt+k |t = Pt +k
Ct+k
mct+k |t = mct+k +
Josef Strsk
Inflation I
Recall:
(p pt+k )
1 t
X
t+k |t + pt+k pt1 )
= (1 )
()k Et (mc
mct+k |t = mct+k
pt pt1
k =0
(37)
Substitute for mct+k |t and compute:

pt pt1 = (1 )
()k Et (mct+k + pt+k pt1 )
k =0
pt pt1
X
X
= (1 )
()k Et (mct+k ) +
()k Et (t+k )
k =0
k =0
1
1+
where =
1. The above condition can be found as a
solution of following difference equation:
p p
Josef Strsk
= (1
)mc
Model
The Basic New Keynesian
+ E (
p )
Inflation II
Recall:
t+k + Et (t+1
pt pt1 = (1 )mc
pt )t
t = (1 )(pt pt )
It might be now derived that:
t
t = Et (t+1 ) + mc
(38)
where = (1)(1)
Inflation results from purposeful price-setting decisions.

(Contrary to classical model where inflation arises from
monetary policy rule.)
Solving forward:
t =
t+k )
k Et (mc
k =0
Josef Strsk
(39)
Natural output
Recall and compute:
mct = (wt pt ) mpnt
mct = (yt + nt ) (yt nt ) log(1 )
+
1+
mct = ( +
)yt
at log(1 )
1
1
+ n 1+
)y
at log(1 )
mc = ( +
1 t
1
The second row follows from households intratemporal optimality
condition and the third one follows from yt = (1 )nt + at . Last
equation assumes flexible prices for that mct = mc and we denote
equilibrium level of output under flexible prices as natural level of
output ytn . We may write:
n
ytn = ya
at + ny
1+
n
Where ya
= (1)++
and ny = (1)(log(1)
. Notice that
(1)+
when = 0 (perfect competition) the natural level corresponds to the
classical equilibrium level of output. The firms market power lowers
the output uniformly without changing sensitivity to technology.
Josef Strsk
New Keynesian Phillips Curve

t we may write:
By subtracting mct mc = mc
+
)(yt ytn )
1
+
t = ( +
)yt
mc
1
t = ( +
mc
We introduced output gap yt .

Recall:
t
t = Et (t+1 ) + mc
(40)
We finally get New Keynesian Phillips Curve

t = Et (t+1 ) + yt

where = +
+
1

Josef Strsk
(41)
Dynamic IS equation
Dynamic Investment-Savings equation follows from intertemporal
optimality condition:
1
(it Et (t+1 ) rtn )
where rtn is natural rate of interest, given by:

yt = Et (yt+1 )
(42)
rtn = + Et (yt+1 )
n
rtn = + ya
Et (at+1 )
By solving forward we may write:
yt =
1X
n
(rt+k rt+k
)
(43)
k =0
where rt = it Et (t+1 ).
Inflation is determined by output gap through New Keynesian Philips
Curve and the output gap is given by path of evolution of real interest
rate. Real interest rate might be evaluated only by description of
monetary policy. Monetary policy is then non-neutral in contrast to the
classical model.
Josef Strsk

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The Basic New Keynesian Model

12th May 2011