In this chapter we introduce a perfectly competitive “new classical” model of aggregate fluctuations in which there is no capital accumulation. This is a dynamic stochastic general equilibrium models (DSGE), based on optimizing households and firms, flexible wages and prices, and fully competitive markets. Fluctuations are caused by real shocks to productivity, but we abstract from capital accumulation which propagates the dynamic effects of such shocks in the stochastic growth model of Chapter 11.

The reason for introducing this simplified model, is to have a “new classical” model which is comparable to the “new keynesian” models that we shall analyze in subsequent chapters, so that we can better understand the similarities and differences between the “new classical” and the “new keynesian” approaches to aggregate fluctuations.

The main impulses that generate aggregate fluctuations are real, i.e shocks to productivity. However, we also analyze the role of monetary shocks and monetary policy in this class of “new classical” models.

Monetary shocks have no real effects on output, employment and other real variables in this model, and only affect real money balances, and nominal variables such as the price level, inflation and nominal wages and interest rates. Thus, the role of monetary policy in this model is simply to stabilize inflation in the presence of monetary and real shocks.

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