In this chapter we present the structure of an alternative new Keynesian model of aggregate fluctuations. The model is a dynamic stochastic general equilibrium model based on monopolistic competition in product markets, and we analyze it assuming both full adjustment of wages and prices and staggered pricing. The model with full adjustment of wages and prices is comparable to the “new classical model” without capital analyzed in Chapter 11, and the model with staggered pricing is comparable to the “new keynesian” model with periodic nominal wage contracts, analyzed in Chapter 13.

The imperfectly competitive “new Keynesian” model has two important differences from the typical perfectly competitive “new classical” model.

First, instead of fully competitive markets for goods and services, it assumes that markets are characterized by conditions of monopolistic competition. Firms do not take prices as given, but determine prices so as to maximize profits. Because of monopolistic competition, employment, real output, consumption and real wages are determined at a lower level than in the corresponding competitive model, even when there is complete flexibility in prices and wages. However, by itself this difference does not result in major differences from the “new classical” competitive model regarding the nature of macroeconomic fluctuations.

Second, in the imperfectly competitive new Keynesian model it is usually assumed that firms adjust prices only gradually. Two observationally equivalent versions of gradual price adjustment have dominated the literature. The one is the Rotemberg (1982 a,b) model of monopolistic price adjustment, and the second is the Calvo (1983) model of staggered pricing. In the Rotemberg model, firms balance the costs of adjusting prices against the costs of deviating from the profit maximizing optimal price. They end up gradually adjusting prices, so as to gradually approach the optimal price. In the Calvo model, it is assumed that only a fixed proportion of firms have the freedom to adjust prices in any given period. This results in the remaining firms not being able to adjust prices. Although optimal pricing takes this restriction into account in advance, the aggregate price level adjusts only gradually. These two alternative assumptions lead to models with price level stickiness, which differ significantly from the new classical models, and share many of the properties of the “new keynesian” model with periodic nominal wage contracts.

In the “new keynesian” model with periodic nominal wage contracts it is only deviations of current inflation from prior expectations of current inflation that result in deviations of output and unemployment from their “natural rates”. In the staggered pricing model, it is deviations of inflation from expected future inflation that are associated with such deviations. This results in a different type of Phillips curve, called the new keynesian Phillips curve, which differs from the traditional expectations augmented Phillips curve, as current inflation depends on current expectations of future inflation, and not prior expectations of current inflation.

The imperfectly competitive new Keynesian model has the following structure:

Deviations of inflation from the target of the central bank are determined by the “new Keynesian” Phillips curve, and depend of expected future inflation and deviations of real output from its “natural” level, as the latter cause an increase in nominal marginal costs and hence prices.

The deviations of aggregate demand from the “natural” level of real output depend on the new Keynesian IS curve, which, as in the periodic nominal wage contracts model, depend on deviations of the current real interest rate from its “natural” level.

The nominal interest rate is determined by the central bank, which follows a Taylor interest rate rule. According to the Taylor rule, the nominal interest rate reacts positively to deviations of current inflation from the central bank target, as well as deviations of real output from its “natural” level.

After presenting the properties of this model, we analyze the effects of monetary and real shocks on fluctuations in real output and the price level (inflation).

The imperfectly competitive new keynesian model with staggered prices can, unlike the classical model, explain monetary cycles, i.e aggregate fluctuations caused by monetary shocks. These shocks are transmitted to real variables, and, to the extent that they persist over time, have persistent real effects. However, due to the absence of labor market distortions, this model cannot account for “involuntary” unemployment. A more satisfactory generalized “new keynesian” model must rely on labor market distortions as well.

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