1.Monetary transmission depends critically on private sector expecta- tions of the future path of the central bank's policy instrument,the short term interest rate.Ever since the rational expectations revolution,it has been well understood that the effects of monetary policy depend on private sector expectations.This early literature,however,typically studied how ex- pectations formation influenced the effect of a contemporaneous shift in the money supply on real versus nominal variables.2 In this regard,the new liter- ature differs in two important ways.First,as we discuss below,it recognizes that central banks typically employ a short term interest rate as the policy instrument.Second,within the model,expectations of the future perfor- mance of the economy enter the structural equations,since these aggregate relations are built on forward looking decisions by individual households and firms.As a consequence,the current values of aggregate output and infla- tion depend not only on the central bank's current choice of the short term interest rate,but also on the anticipated future path of this instrument.The practical implication is that how well the central bank is able to manage private sector expectations about its future policy settings has important consequences for its overall effectiveness.Put differently,in these paradigms the policy process is as much,if not more,about communicating the future intentions of policy in a transparent way,as it is about choosing the current policy instrument.In this respect,these models provide a clear rationale for the movement toward greater transparency in intentions that central banks around the globe appear to be pursuing 2.The natural (flerible price equilibrium)values of both output and the 2See.e.g.Fischer(1977)and Taylor (1980)
1. Monetary transmission depends critically on private sector expectations of the future path of the central bankís policy instrument, the short term interest rate. Ever since the rational expectations revolution, it has been well understood that the e§ects of monetary policy depend on private sector expectations. This early literature, however, typically studied how expectations formation ináuenced the e§ect of a contemporaneous shift in the money supply on real versus nominal variables.2 In this regard, the new literature di§ers in two important ways. First, as we discuss below, it recognizes that central banks typically employ a short term interest rate as the policy instrument. Second, within the model, expectations of the future performance of the economy enter the structural equations, since these aggregate relations are built on forward looking decisions by individual households and Örms. As a consequence, the current values of aggregate output and ináation depend not only on the central bankís current choice of the short term interest rate, but also on the anticipated future path of this instrument. The practical implication is that how well the central bank is able to manage private sector expectations about its future policy settings has important consequences for its overall e§ectiveness. Put di§erently, in these paradigms the policy process is as much, if not more, about communicating the future intentions of policy in a transparent way, as it is about choosing the current policy instrument. In this respect, these models provide a clear rationale for the movement toward greater transparency in intentions that central banks around the globe appear to be pursuing. 2. The natural (áexible price equilibrium) values of both output and the 2See. e.g. Fischer (1977) and Taylor (1980) 4
real interest rate provide important reference points for monetary policy-and may fluctuate considerably.While nominal rigidities are introduced in these new models in a more rigorous manner than was done previously,it remains true that one can define natural values for output and the real interest rate that would arise in equilibrium if these frictions were absent.These nat- ural values provide important benchmarks,in part because they reflect the (constrained)efficient level of economic activity and also in part because monetary policy cannot create persistent departures from the natural values without inducing either inflationary or defationary pressures.Within tra- ditional frameworks,the natural levels of output and the real interest are typically modeled as smoothed trends.Within the new frameworks they are modelled explicitly.Indeed,roughly speaking,they correspond to the values of output and the real interest rate that a frictionless real business cycle model would generate,given the assumed preferences and technology. As real business cycle theory suggests,further,these natural levels can vary considerably,given that the economy is continually buffeted by "real"shocks including oil price shocks,shifts in the pace of technological change,tax changes,and so on.Thus,these new models identify tracking the natural equilibrium of the economy,which is not directly observable,as an important challenge for central banks. In the next section,we lay out a canonical baseline model that captures the key features of the new macro models and we draw out the correspond- ing insights for monetary policy.We then discuss some of the policy issues brought by the new models.We conclude by discussing some modifications of the baseline model that are necessary to take it to data,as well as other 5
real interest rate provide important reference points for monetary policyñand may áuctuate considerably. While nominal rigidities are introduced in these new models in a more rigorous manner than was done previously, it remains true that one can deÖne natural values for output and the real interest rate that would arise in equilibrium if these frictions were absent. These natural values provide important benchmarks, in part because they reáect the (constrained) e¢ cient level of economic activity and also in part because monetary policy cannot create persistent departures from the natural values without inducing either ináationary or deáationary pressures. Within traditional frameworks, the natural levels of output and the real interest are typically modeled as smoothed trends. Within the new frameworks they are modelled explicitly. Indeed, roughly speaking, they correspond to the values of output and the real interest rate that a frictionless real business cycle model would generate, given the assumed preferences and technology. As real business cycle theory suggests, further, these natural levels can vary considerably, given that the economy is continually bu§eted by "real" shocks including oil price shocks, shifts in the pace of technological change, tax changes, and so on. Thus, these new models identify tracking the natural equilibrium of the economy, which is not directly observable, as an important challenge for central banks. In the next section, we lay out a canonical baseline model that captures the key features of the new macro models and we draw out the corresponding insights for monetary policy. We then discuss some of the policy issues brought by the new models. We conclude by discussing some modiÖcations of the baseline model that are necessary to take it to data, as well as other 5
extensions designed to improve its realism. 1 A Baseline Model In this section we lay out a baseline framework that captures the key features of the new vintage macro models and is useful for qualitative analysis.The specific framework we develop is a variant of the canonical model discussed in Goodfriend and King (1997),Clarida,Gali and Gertler(1999),Woodford (2003),and Gali (2007),among others,but modified to allow for investment.3 As with the real business cycle paradigm,the starting point is a stochas- tic dynamic general equilibrium model.More specifically,it is a stochastic version of the conventional neoclassical growth model,modified to allow for variable labor supply.4 As we suggested above,in order to make the frame- work suitable for monetary policy analysis,it is necessary not only to intro- duce nominal variables explicitly,but also some form of nominal stickiness. In this regard,three key ingredients that are the prominent features of the New Keynesian paradigm are added to the frictionless real business cycle model:money,monopolistic competition and nominal rigidities.We briefly discuss each in turn: The key role of money emphasized in the new monetary models is its 3We have avoided a label for the new frameworks because a variety have been used. Goodfriend and King employ the term "New Neoclassical Synthesis,"while Woodford uses "NeoWicksellian.At the insistence of a referee.Clarida.Gali and Gertler used "New Keynesian."The latter term has probably become the most popular,though it does not adequately reflect the influence of real business cycle theory. 4We note that the real business cycle model treats shocks to total factor productivity as the main driving force of business cycles.By contrast,estimated versions of the new mon- etary models suggest that intertemportal disturbances(i.e.,shocks to either consumption or investment spending)are key.See,e.g.Gali and Rabanal(2005),Smets and Wouters (2006)or Primiceri,Schaumberg and Tambalotti (2006). 6
extensions designed to improve its realism. 1 A Baseline Model In this section we lay out a baseline framework that captures the key features of the new vintage macro models and is useful for qualitative analysis. The speciÖc framework we develop is a variant of the canonical model discussed in Goodfriend and King (1997), Clarida, Gali and Gertler (1999), Woodford (2003), and GalÌ (2007), among others, but modiÖed to allow for investment.3 As with the real business cycle paradigm, the starting point is a stochastic dynamic general equilibrium model. More speciÖcally, it is a stochastic version of the conventional neoclassical growth model, modiÖed to allow for variable labor supply.4 As we suggested above, in order to make the framework suitable for monetary policy analysis, it is necessary not only to introduce nominal variables explicitly, but also some form of nominal stickiness. In this regard, three key ingredients that are the prominent features of the New Keynesian paradigm are added to the frictionless real business cycle model: money, monopolistic competition and nominal rigidities. We brieáy discuss each in turn: The key role of money emphasized in the new monetary models is its 3We have avoided a label for the new frameworks because a variety have been used. Goodfriend and King employ the term "New Neoclassical Synthesis," while Woodford uses "NeoWicksellian." At the insistence of a referee, Clarida, Gali and Gertler used "New Keynesian." The latter term has probably become the most popular, though it does not adequately reáect the ináuence of real business cycle theory. 4We note that the real business cycle model treats shocks to total factor productivity as the main driving force of business cycles. By contrast, estimated versions of the new monetary models suggest that intertemportal disturbances (i.e., shocks to either consumption or investment spending) are key. See, e.g. GalÌ and Rabanal (2005), Smets and Wouters (2006) or Primiceri, Schaumberg and Tambalotti (2006). 6
function as a unit of account,i.e.as the unit in which the prices of goods and assets are quoted.The existence of money thus gives rise to nominal prices.It is important,however,to distinguish between money and monetary policy:Monetary policy affects real activity in the short run purely through its impact on market interest rates.In particular,the central bank affects aggregate spending by controlling the short term interest rate and,through market expectations of its future short rate decisions,by influencing the full yield curve.To control the short term interest rate,the central bank adjusts the money supply to accommodate the demand for money at the desired interest rate.These movements in the money supply,however,exert no independent effect on aggregate demand.Because real money balances are a negligible component of total wealth,the models are designed in a way that abstracts from wealth effects of money on spending.Thus,while monetary policy is central in these models,money per se plays no role other than to provide a unit of account. In order to introduce price stickiness in a rigorous way,it is necessary that firms be price-setters as opposed to price-takers.For this reason,it is necessary to introduce some form of imperfect competition,where firms face downward sloping demand curves and,thus,a meaningful price-setting decision.A version of the Dixit-Stiglitz(1977)model of monopolistic compe- tition in which each firm produces a differentiated good and sets the price for the latter while taking as given all aggregate variables provides a simple way to accomplish this and has generally been adopted by the new frameworks. As with traditional models,what ultimately permits monetary policy to have leverage over the real economy in the short run is the existence 7
function as a unit of account, i.e. as the unit in which the prices of goods and assets are quoted. The existence of money thus gives rise to nominal prices. It is important, however, to distinguish between money and monetary policy: Monetary policy a§ects real activity in the short run purely through its impact on market interest rates. In particular, the central bank a§ects aggregate spending by controlling the short term interest rate and, through market expectations of its future short rate decisions, by ináuencing the full yield curve. To control the short term interest rate, the central bank adjusts the money supply to accommodate the demand for money at the desired interest rate. These movements in the money supply, however, exert no independent e§ect on aggregate demand. Because real money balances are a negligible component of total wealth, the models are designed in a way that abstracts from wealth e§ects of money on spending. Thus, while monetary policy is central in these models, money per se plays no role other than to provide a unit of account. In order to introduce price stickiness in a rigorous way, it is necessary that Örms be price-setters as opposed to price-takers. For this reason, it is necessary to introduce some form of imperfect competition, where Örms face downward sloping demand curves and, thus, a meaningful price-setting decision. A version of the Dixit-Stiglitz (1977) model of monopolistic competition in which each Örm produces a di§erentiated good and sets the price for the latter while taking as given all aggregate variables provides a simple way to accomplish this and has generally been adopted by the new frameworks. As with traditional models, what ultimately permits monetary policy to have leverage over the real economy in the short run is the existence 7
of temporary nominal rigidities.Because nominal prices adjust sluggishly, by directly manipulating nominal interest rates,the central bank is able to influence real rates and hence real spending decisions,at least in the short run.The traditional models introduce sluggish price adjustment by postulating a "Phillips curve"relating inflation to some measure of excess demand,as well as lags of past inflation.By contrast,these new vintage models derive an inflation equation-often referred to as the New Keynesian Phillips curve-explicitly from individual firms'price setting behavior,as we describe below. We now turn to a description of our canonical framework.As with the tra- ditional framework,it is convenient to organize the system into three blocks: aggregate demand,aggregate supply,and policy.Further,it is possible to represent each sub-sector by a single equation.In an appendix available with the online version of this paper(at http://www.e-jep.org),we build up the aggregate demand and aggregate supply relationships in detail.In what fol- lows,we present the condensed aggregate demand and supply equations along with an informal motivation.By adding an additional relation that describes monetary policy,it is then possible to express the model as a simple three equation system,similar in spirit to the way traditional models have been represented.The main difference with the traditional framework,of course, is that the new vintage of models are built on explicit micro foundations. 8
of temporary nominal rigidities. Because nominal prices adjust sluggishly, by directly manipulating nominal interest rates, the central bank is able to ináuence real rates and hence real spending decisions, at least in the short run. The traditional models introduce sluggish price adjustment by postulating a ìPhillips curveî relating ináation to some measure of excess demand, as well as lags of past ináation. By contrast, these new vintage models derive an ináation equationñoften referred to as the New Keynesian Phillips curveñexplicitly from individual Örmsíprice setting behavior, as we describe below. We now turn to a description of our canonical framework. As with the traditional framework, it is convenient to organize the system into three blocks: aggregate demand, aggregate supply, and policy. Further, it is possible to represent each sub-sector by a single equation. In an appendix available with the online version of this paper (at http://www.e-jep.org), we build up the aggregate demand and aggregate supply relationships in detail. In what follows, we present the condensed aggregate demand and supply equations along with an informal motivation. By adding an additional relation that describes monetary policy, it is then possible to express the model as a simple three equation system, similar in spirit to the way traditional models have been represented. The main di§erence with the traditional framework, of course, is that the new vintage of models are built on explicit micro foundations. 8