Since the 1970s, the macroeconomics of aggregate fluctuations has been emphasizing the microeconomic foundations of all behavioral relations, and in particular the consumption and investment functions and the short-term determination of wages, prices and the equilibrium unemployment rate. In addition, the “rational expectations” hypothesis, which requires that households and firms form their expectations about future variables, taking into account the actual process determining the evolution of these variables, has become the dominant expectations hypothesis. The hypothesis of adaptive expectations, was gradually abandoned. Thus, macroeconomic models of aggregate fluctuations gradually evolved into dynamic stochastic general equilibrium models based on rational expectations.

The “new classical” model is an example of such a model, in which wages and prices are perfectly flexible and equilibrate both the product and labor markets. In “new classical” models, only real shocks, such as shocks to productivity, can affect the fluctuations of output, employment and other real variables. Monetary shocks only affect nominal variables, such as the price level and inflation. In addition, employment fluctuations are based on inter temporal substitution and, thus, there is no involuntary unemployment in the “new classical” model.

The short run neutrality of money implied by “new classical” models was initially troublesome for their proponents, as these models were not compatible with the existence of a positive short run relation between inflation and employment, as suggested by the expectations augmented Phillips curve. Lucas (1972, 1973), developed a “new classical model” which was consistent with a positive short run relation between inflation and employment. This model, which was subsequently implemented empirically by Sargent (1973, 1976), was based on the assumption that firms did not have full information about the price level at the time they made their production decisions, and they attributed part of any change in the price level to a change in the relative price of their product. Thus, when inflation was unexpectedly high, all producers thought the relative price of their output had gone up, and thus increased production and employment. The opposite happened when inflation was unexpectedly low.

However, this “new classical” explanation of the short run relation between inflation and output and employment was still not compatible with involuntary unemployment, and could only account for temporary deviations of output and employment from their “natural levels”, due to inter-temporal substitution in labor supply and unanticipated inflation.

An alternative approach, due to Gray (1976), Fischer (1977) and Taylor (1979), emphasized periodic nominal wage contracts. This approach descended directly from the *General Theory,* treating nominal wages as temporarily fixed. In the Gray-Fischer model, nominal wage contracts are assumed to be negotiated at the beginning of every period, or at the beginning of alternate periods. In addition, nominal wages are assumed to remain fixed for the duration of the contract. Thus, nominal wages depend on prior expectations about the evolution of the price level, productivity and all other shocks. If inflation turns out to be higher than expected, then real wages fall, firms demand more labor, and employment rises. The opposite happens when inflation turns out to be lower than expected. Thus, these models have keynesian features, and have formed the basis of the so called new keynesian approach to aggregate fluctuations.

In this chapter we analyze a “new Keynesian” model based on such periodic nominal wage contracts, which is comparable to the “new classical” model without capital. It not only allows for nominal shocks and monetary policy to affect the fluctuations of real variables, but it also allows for the existence of “involuntary” unemployment. The model builds on one of the key insights of the General Theory, namely the short run rigidity of nominal wages, as envisaged by Gray and Fischer contracts. In all other respects it is based on inter-temporal optimization on the part of both households and firms.

The model is a dynamic, stochastic general equilibrium model, in which non indexed nominal wage contracts are negotiated periodically by “insiders” in the labor market. There are two distortions in this model compared to the “new classical” model without capital. The first is a real distortion, arising from the fact that “outsiders” are disenfranchised from the labor market. As a result, wage contracts do not seek to maintain full employment and there is a positive “natural” rate of unemployment. The second is a nominal distortion, arising from the fact that nominal wage contracts are not indexed, and can only be reopened at the beginning of each period, before the realization of current nominal and real shocks. Thus, nominal wages are set on the basis of prior rational expectations about the various unobserved shocks.

The real distortion in our model makes the “natural” rate of unemployment inefficiently high, while the nominal distortion allows for nominal shocks to have temporary real effects. Thus, nominal shocks and, by extension, monetary policy, are able to affect fluctuations in both inflation and real variables such as output, employment, unemployment, real wages and the real interest rate.

The model is characterized by an expectations augmented “Phillips curve”, in which deviations of output and employment from their “natural” level depend on unanticipated current inflation, and unanticipated productivity shocks, which affect the relation between real wages and productivity.

Aggregate demand is determined by the optimal behavior of a representative household, with access to a competitive financial market, choosing the path of consumption and real money balances in order to maximize its inter-temporal utility function. Thus, both the consumption function and the money demand function are derived from inter-temporal microeconomic foundations. The model is also characterized by exogenous shocks to productivity, preferences for consumption and money demand, as well as labor market shocks.

Thus, the model is in essence a dynamic stochastic model that incorporates many of the features of the AS-AD version of the traditional Keynesian model.

We analyze aggregate fluctuations in this model under two alternative monetary regimes. The first is an exogenous process for the rate of growth of the money supply and the second is a feedback interest rate rule, according to which the nominal interest rate responds to deviations of inflation from the target of the central bank, and deviations of output from its “natural” level.

Contrary to the “new classical” model, monetary shocks affect real variables in this model, causing temporary deviations of output, employment, unemployment, real wages and the real interest rate from their “natural” levels. The exact variance of such deviations depends on the monetary rule. Under an exogenous process for the rate of growth of the money supply, all shocks affect aggregate fluctuations. Under a feedback interest rate rule, only productivity and nominal interest rate shocks affect aggregate fluctuations. We thus demonstrate the dependence of aggregate fluctuations not only on exogenous shocks, but on the form of the monetary policy rule followed by the central bank.

We also extend the model to account for persistence in deviations of unemployment and output from their “natural” levels. The extension is based on a dynamic model of the “Phillips Curve”, in which unanticipated shocks to inflation and productivity have persistent effects on unemployment, and these persistent effects are compatible with full inter-temporal optimization on the part of labor market “insiders”. The propagation mechanism that causes unanticipated nominal and real shocks to produce persistent deviations of unemployment and output from their “natural” rate is the partial adjustment of labor market insiders to employment shocks. We demonstrate that under a Taylor rule, the only shocks that cannot be completely neutralized by monetary policy are productivity shocks and, of course, monetary policy shocks. Fluctuations of deviations of unemployment and output from their “natural” rates display persistence and are driven by these two types of shocks. Because of the endogenous persistence of deviations of unemployment from its “natural” rate, the equilibrium inflation rate also displays persistence around the inflation target of the central bank.

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