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Monetary Policy, Inflation, and the Business Cycle

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Monetary Policy, Inflation, and the Business Cycle
An Introduction to the New Keynesian Framework

Jordi Galí

Princeton University Press Princeton and Oxford

Copyright © 2008 by Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW All Rights Reserved Library of Congress Cataloging-in-Publication Data Galí, Jordi, 1961– Monetary policy, inflation, and the business cycle : an introduction to the New Keynesian framework / Jordi Galí. p. cm. Includes bibliographical references and index. ISBN 978-0-691-13316-4 (hbk. : alk. paper) 1. Monetary policy. 2. Inflation (Finance). 3. Business cycles. 4. Keynesian economics. I. Title. HG230.3.G35 2008 339.5'3—dc22 2007044381 British Library Cataloging-in-Publication Data is available This book has been composed in Times Roman by Westchester Book Group. Printed on acid-free paper. ∞ press.princeton.edu Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

Als meus pares

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Contents

Preface 1 Introduction 2 A Classical Monetary Model 3 The Basic New Keynesian Model 4 Monetary Policy Design in the Basic New Keynesian Model 5 Monetary Policy Tradeoffs: Discretion versus Commitment 6 A Model with Sticky Wages and Prices 7 Monetary Policy and the Open Economy 8 Main Lessons and Some Extensions Index

ix 1 15 41 71 95 119 149 185 195

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Preface

This book brings together some of the lecture notes that I have developed over the past few years, and which have been the basis for graduate courses on monetary economics taught at different institutions, including Universitat Pompeu Fabra (UPF), Massachusetts Institute of Technology (MIT), and the Swiss Doctoral Program at Gerzensee. The book’s main objective is to give an introduction to the New Keynesian framework and some of its applications. That framework has emerged as the workhorse for the analysis of monetary policy and its implications for inflation, economic fluctuations, and welfare. It constitutes the backbone of the new generation of medium-scale models under development at the International Monetary Fund, the Federal Reserve Board, the European Central Bank (ECB), and many other central banks. It has also provided the theoretical underpinnings to the inflation stability-oriented strategies adopted by the majority of central banks in the industrialized world. A defining feature of this book is the use of a single reference model throughout the chapters. That benchmark framework, which I refer to as the “basic New Keynesian model,” is developed in chapter 3. It features monopolistic competition and staggered price setting in goods markets, coexisting with perfectly competitive labor markets. The “classical model” introduced in chapter 2, characterized by perfect competition in goods markets and flexible prices, can be viewed as a limiting case of the benchmark model when both the degree of price stickiness and firms’ market power vanish. The discussion of the empirical shortcomings of the classical monetary model provides the motivation for the development of the New Keynesian model, as discussed in the introductory chapter. The implications for monetary policy of the basic New Keynesian model, including the desirability of inflation targeting, are analyzed in chapter 4. Each of the subsequent chapters then builds on the basic model and analyzes an extension of that model along some specific dimension. Once the reader has grasped the contents of chapters 1 through 4, each subsequent chapter can be read independently, and in any order. Thus, chapter 5 introduces a policy tradeoff in the form of an exogenous cost-push shock that serves as the basis for a discussion of the differences between...
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