FoundationsfortheNew

KeynesianModelII
LawrenceJ.Christiano
StandardNewKeynesianModel y
(NKmodeloflasttime,withTaylorrule)
Taylorrule:designed,sothatinsteadystate,
inflationiszero()
m 1
Employmentsubsidyextinguishesmonopoly p y y g p y
powerinsteadystate:
1 v
c
1 1 v
c 1
1
EquationsoftheNKModel
1
C
t
E
t
[
C
t1
R
t
m
t1
0
1 E
t
m
t1
c1
[0F
t1
F
t
0
1
1
C N

F
t
10m
t
c1
10
1c
K
t
0
C
t
p
t

e
a
t
N
t
0
1 0
c 1
c
0
c
1 v
c
c1
C
t
expt
t
N
t

e
a
t
E
t
[0m
t1
c
K
t1
K
t
0
1
p
t

1 0
10m
t

c1
10
c1

0m
t
c
p
t1

0
Insteadystate:
R
1
[
, p

1, F K
1
1 [0
, N exp
0
1
.
EquationsoftheNKModelUnderthe
Optimal Policy (Natural Equilibrium) OptimalPolicy(NaturalEquilibrium)
Outputandemployment(inlogs)
y
t

a
t

1
t
t
n
t

1
t
t
I t t l E l ti ft t ki l
y
t
a
t
1
t
t
, n
t
1
t
t
IntertemporalEulerequationaftertakinglogs
andignoringV adjustmentterm:
y
t

r
t

E
t
m
t1

rr E
t
y
t1

, rr log[
Natural Rate of Interest NaturalRateofInterest
Intertemporal euler equation in natural Intertemporal euler equationinnatural
equilibrium:
y
t
y
t1

Back out the natural rate:

a
t

1
1
t
t
r
t

rr E
t
a
t1

1
1
t
t1
Backoutthenaturalrate:
r
t

rr a
t

1
1
1 zt
t
Shocks:
t

t
1

t
t
t
zt
t1
c
t
t
, a
t
a
t1
c
t
NK IS Curve NKISCurve
Eulerequationintwoequilibria:
Taylor rule equilibrium: y
t
r
t
E
t
m
t1
rr E
t
y
t1
Natural equilibrium: y
t

r
t

rr E
t
y
t1

Subtract
Natural equilibrium: y
t
r
t
rr E
t
y
t1
Subtract:
Outputgap
x r E m
1
r

E x
1
x
t
r
t
E
t
m
t1
r
t
E
t
x
t1
Output in NK Equilibrium OutputinNKEquilibrium
Agg output relation: Aggoutputrelation:
0 if P
i t
P
j t
for all i j
y
t
logp
t

n
t
a
t
, logp
t

0 if P
i,t
P
j,t
for all i, j
0 otherwise
.
Tofirstorderapproximation,
p

0p

t1

0 m
t
, p
t

1
PriceSettingEquations
Loglinearlyexpandthepricesettingequations
aboutsteadystate.
1
y
1 E
t
m
t1
c1
[0F
t1
F
t
0
F
t
10m
t
c1
10
1
1c
K
t
0
1 v
c
c1
C
t
expt
t
N
t

e
a
t
E
t
[0m
t1
c
K
t1
K
t
0
Result:

1[010
1 [

See h //f l h d / l h / / l h d df
m
t

[
0
1 x
t
[m
t1
Seehttp://faculty.wcas.northwestern.edu/~lchrist/course/solving_handout.pdf
Taylor Rule TaylorRule
Policy rule Policyrule
1 r
t
r or
t1
r 1 orr
m
m
t

x
x
t

EquationsofActualEquilibrium
Closed by Adding Policy Rule ClosedbyAddingPolicyRule
[E
t
m
t1
kx
t
m
t
0 (Phillips curve)
r
t
E
t
m
t1
r
t

E
t
x
t1
x
t
0 (IS equation)
or
t1
1 o
m
m
t
1 o
x
x
t
r
t
0 (policy rule)
r
t

a
t

1
1
1 zt
t
0 (definition of natural rate)
SolvingtheModel
s
t

a
t
t
t

0
0 z
a
t1
t
t1

c
t
c
t
t
s
t
Ps
t1
c
t
[ 0 0 0 m
t1
1 k 0 0 m
t
1
o
1 0 0
0 0 0 0
0 0 0 0
x
t1
r
t1
r
1

0 1
1
o
1
o
1 o
m
1 o
x
1 0
0 0 0 1
x
t
r
t
rr
t

0 0 0 0 r
t1
0 0 0 1 rr
t

0 0 0 0
0 0 0 0
m
t1
x
t1

0 0 0
0 0 0

0 0
0 0

0 0 o 0
0 0 0 0
r
t1
r
t1

0 0 0
0 0 0
s
t1

0 0
o
1
o
1 z
s
t
E
t
o
0
z
t1
o
1
z
t
o
2
z
t1
[
0
s
t1
[
1
s
t
0
SolvingtheModel
E
t
o
0
z
t1
o
1
z
t
o
2
z
t1
[
0
s
t1
[
1
s
t
0
s
t
Ps
t1
c
t
0.
Solution:
z
t
Az
t1
Bs
t
Asbefore:
o
0
A
2
o
1
A o
2
I 0 o
0
A o
1
A o
2
I 0,
F [
0
o
0
BP [
1
o
0
A o
1
B 0

x
0,
m
1. 5, [ 0. 99, 1, 0. 2, 0 0. 75, o 0, o 0. 2, z 0. 5.
Dynamic Response to a Technology Shock
0 02
0.03
inflation
0 1
0.15
output gap
0.15
0.2
nominal rate
natural nominal rate
actual nominal rate
0 2 4 6
0.01
0.02
0 2 4 6
0.05
0.1
0 2 4 6
0.05
0.1
actual nominal rate
0.1
0.15
0.2
natural real rate
1
log, technology
1.15
1.2
output
natural output
actual output
0 2 4 6
0.05
0 2 4 6
0
0.5
0 2 4 6
1
1.05
1.1
employment
natural employment
0.1
0.15
0.2
p y
natural employment
actual employment
0 5 10
0
0.05
inflation output gap nominal rate
Dynamic Response to a Preference Shock
0 04
0.06
0.08
0.1
inflation
0.15
0.2
0.25
output gap
0 1
0.15
0.2
0.25
nominal rate
natural real rate
actual nominal rate
0 2 4 6
0.02
0.04
0 2 4 6
0.05
0.1
0 2 4 6
0.05
0.1
natural real rate preference shock output
0.1
0.15
0.2
0.25
0.5
1
-0.3
-0.2
-0.1
natural output
0 2 4 6
0.05
0 2 4 6
0
0 2 4 6
-0.5
-0.4
actual output
employment
natural employment
actual employment
0 4
-0.3
-0.2
-0.1
0 2 4 6
-0.5
-0.4