Lecture 1:

The basic New Keynesian model

Prof. Michael Weber

University of Chicago Booth School of Business

September 15, 2015

1)
Lecture Outline

I Introduction
I Derivation of Calvo Model
I Interpretation and Solution

2)
Introduction

3)
About Me

I Joined Booth in 2014

I Master in Business Economics from University of Mannheim
I PhD from Haas School of Business, UC Berkeley
I Research interests:
I Asset pricing, Macroeconomics, Household Finance,
International Finance
I Specific research topics:
1. Downside Risk across Asset Classes
2. Effects of firms’ inability to adjust output prices to
macroeconomic shocks (confidential BLS microdata)
3. Microfoundations of price ridigities
4. Distrust in finance and stock market participation
5. Term structure of equity returns (anomalies)
6. Production networks, real effects of monetary shocks
→ http://faculty.chicagobooth.edu/michael.weber
I Work experience
I Investment banking
I Consulting
4)
Contact Information

Professor Michael Weber

Email: michael.weber@chicagobooth.edu
Tel. +1 510 725 9033
Office hours
I Wednesday 3.30 pm – 5.00 pm or by appointment

5)
Derivation of Calvo Model

6)
Household’s Problem

I The household solves the following optimization problem:

 C 1−ψ 1+1/η
X X
t Lt 
max E β t U(Ct , Lt ) = E βt −
1−ψ 1 + 1/η

where Ct is consumption index (Dixit-Stiglitz aggregator):

Z 1 σ−1
 σ
σ−1
Ct = Ct (i) σ di
0

Ct (i): variety i ∈ [0, 1] from the continuum of goods

ψ: inverse of the intertemporal elasticity of substitution (IES)
η: Frisch labor supply elasticity

7)
Household’s Problem cont.

I The budget constraint is:

Z 1
Pt (i)Ct (i)di + Qt Bt = Bt−1 + Wt Lt
0

Qt : price of zero coupon bond Bt

I One can show that the optimal consumption of good i is:

 P (i) −σ
t
Ct (i) = Ct
Pt

8)
Household’s Problem cont.

I The price of the optimal consumption (also the price index) is:

1
Z 1  1−σ
1−σ
Pt ≡ Pt (i) di
0

I Then the price of the optimal bundle is:

Z 1 
Pt (i)Ct (i)di = Pt Ct
0

I This allows us to simplify the budget constraint.

9)
Household’s Problem cont.

I The FOCs are:

UL0 Wt
− = (1)
UC0 Pt
h U0 Pt i
C ,t+1
Qt = βEt (2)
UC0 ,t Pt+1

I Equation 2: Euler equation governing intertemporal allocation

I Equation 1: intratemporal condition, can be rewritten as:

1/η
Lt Wt
= ⇒ W̌t − P̌t = ψ Čt + 1/η Lˇt
Ct−ψ Pt

10 )
Household’s Problem cont.

I Let Qt ≡ 1/ exp(it ) ⇒ Q̌t = −it

Pt+1 −Pt
I Define inflation πt+1 = Pt ≈ log (Pt+1 /Pt ) ≈ P̌t+1 − P̌t

I We assume zero steady state inflation rate

I After log-linearizing the Euler equation, we have:

1
Čt = Et [Čt+1 ] − (it − Et [πt+1 ]) (3)
ψ

I If ψ is low, consumption is sensitive to the real interest rate

11 )
Pricing Assumption

I The key ingredient of Calvo’s model is the pricing assumption:

1. Each firm can reset its price only with probability 1 − θ

2. Independence from time since last price adjustment
I Assumption of independent price adjustments is critical
I Allows simple aggregation of prices
I Straightforward dynamics of the aggregate price level

I Assumption also critical problem of the model

I Adjustment function of deviation from optimal price in data

12 )
Pricing Assumption cont.

I Probability of price non-adjustment is θ

1
I Average duration of the price is 1−θ

I We can interpret θ as an index of price stickiness.

13 )
Pricing Assumption cont.

I Aggregate price index dynamics in a symmetric equilibrium:

1
Z 1  1−σ
1−σ
Pt = Pt (i) di
0
1
Z 1−θ Z 1  1−σ
= Pt∗ (i)1−σ di + Pt−1 (i) 1−σ
di
0 1−θ
1
(1 − θ)(Pt∗ )1−σ + θ(Pt−1 )1−σ

1−σ
=

I We used the facts

I Identical reset price Pt∗ as no firm-specific state variable
I Price adjustment is random
R1
I Same composition of prices in 1−θ
Pt−1 (i)1−σ di and
R1
P (i)1−σ di.
0 t−1
14 )
Pricing Assumption cont.

I Now divide both sides of this equation by Pt−1 to get:

 P 1−σ  P ∗ 1−σ
t t
= θ + (1 − θ)
Pt−1 Pt−1

I Log-linearize around zero inflation steady-state:

πt = P̌t − P̌t−1 = (1 − θ)(P̌t∗ − P̌t−1 )

I Inflation rate is the combination of two margins:

I extensive margin = (1 − θ)
I intensive margin = (P̌t∗ − P̌t−1 )
I The extensive margin is fixed in this model
15 )
Firm’s Problem

We’ll make the following assumptions:

I Continuum of firms, i ∈ [0, 1]

I Each firm i is producing a fixed variety

I Production function is Yt (i) = Zt Lt (i)1−α

I Zt is level of technology

I α > 0 yields an upward-sloping marginal cost

I No capital

I Labor is homogenous across firms

 −σ
Pt (i)
I All firms face the same demand curve: Yt (i) = Yt Pt

16 )
Firm’s Problem cont.

I Firms’ pricing problem is dynamic

I Won’t be able to change future prices
I Optimal reset price maximizes present value of profits:

+∞
X h i
max
∗
Et θk Qt,t+k (Pt∗ Yt+k|t − Σt+k (Yt+k|t ))
Pt
k=0

Σt+k : cost function in period t + k

Yt+k|t : output in t + k of firm resetting price at t
Qt,t+k : stochastic discount factor (SDF)

17 )
Firm’s Problem cont.

I SDF obtained from the consumer’s Euler equation:

C −ψ P
t+k t
Qt,t+k = β k
Ct Pt+k

I The firm is subject to the demand constraint:

 P ∗ −σ
t
Yt+k|t = Yt+k
Pt+k

18 )
Firm’s Problem cont.

I First order condition for Pt∗ :

+∞
X h σ i
Et θk Qt,t+k Yt+k|t (Pt∗ − Σ0t+k )) = 0 (4)
σ−1
k=0

σ
µ= σ−1 : desired markup over cost
Σ0t+k marginal cost at time t + k.

I This yields:

σ 0
θk Qt,t+k Yt+k|t σ−1
P
Et Σt+k
Pt∗ = P k
Et θ Qt,t+k Yt+k|t

19 )
Firm’s Problem cont.

I For θ = 0 we find the familiar static condition:

σ
Pt∗ = × MC
σ−1

I Divide equation (4) by Pt−1 to get:

+∞
X h  P∗
t σ Σ0t+k Pt+k i
Et θk Qt,t+k Yt+k|t − =0
Pt−1 σ − 1 Pt+k Pt−1
k=0

20 )
Firm’s Problem cont.

I Define real marginal cost:

Σ0t+k
MCt+k|t =
Pt+k

I Log-linearize around the zero inflation steady state:

+∞
X
Pˇt∗ − P̌t−1 = (1 − βθ) ˇ t+k|t + (P̌t+k − P̌t−1 )
(βθ)k Et MC

k=0

21 )
Firm’s Problem cont.

I Rewrite:

+∞
∗ X
ˇ t+k|t + P̌t+k )
(βθ)k Et MC


P̌t = (1 − βθ)
k=0

∗
I P̌t : weighted average of desired future markups

I Weights depend on θ, which governs the effective horizon

I Low θ ⇒ future does not matter as firms can reset frequently

22 )
Firm’s Problem cont.

I Equilibrium in the goods market implies:

Yt (i) = Ct (i)
Z 1 σ−1
 σ
σ−1
Yt (i) σ di ≡ Yt = Ct
0
Y̌t = Čt

I Equilibrium in the labor market:

Z 1  Z 1  1 
Yt (i)  1−α
Lt = Lt (i)di = di
0 0 Zt
 Y  1 Z 1  P (i)  −σ 
t 1−α t 1−α
= di ⇒
Zt 0 Pt
(1 − α)Lˇt = Y̌t − Zˇt + dˇt
23 )
Firm’s Problem cont.
−σ
R 
1 Pt (i) 1−α
I term dˇt arises from price dispersion 0 ( Pt ) di
I We will ignore term as zero inflation in steady state
I See Gali’s textbook for more rigorous treatment of this term
I Aggregate marginal cost is:

ˇt
MC ˇ t
= (W̌t − P̌t ) − MPL
= (W̌t − P̌t ) − (Žt − αLˇt )
1
= (W̌t − P̌t ) − (Žt − αY̌t )
1−α
ˇ t : average marginal product in the economy
MPL

24 )
Firm’s Problem cont.

I Therefore,

ˇ t+k|t
MC = (W̌t+k − P̌t+k ) − MPLˇ t+k|t
1
= (W̌t+k − P̌t+k ) − (Žt+k − αY̌t+k|t )
1−α
ˇ t+k + α (Y̌t+k|t − Y̌t+k )
= MC
1−α
ασ
ˇ
= MC t+k − (P̌ ∗ − P̌t+k )
1−α t

I We used expressions for demand and marginal cost

I With CRS, MC does not depend on production level

25 )
Firm’s Problem cont.

I We can now compute the optimal reset price as:

+∞
X
Pˇt∗ − P̌t−1 = (1 − βθ) ˇ t+k + (P̌t+k − P̌t−1 )
(βθ)k Et ΘMC

k=0

1−α
Θ= 1−α+ασ

26 )
Firm’s Problem cont.

Pˇt∗ − P̌t−1 = ˇ t + (1 − βθ)Et (P̌t − P̌t−1 )

(1 − βθ)ΘMC
+∞
X
ˇ t+k + (P̌t+k − P̌t−1 )
(βθ)k Et ΘMC


+(1 − βθ)
k=1

Pˇt∗ − P̌t−1 = ˇ t + (1 − βθ)Et (P̌t − P̌t−1 )

(1 − βθ)ΘMC
+∞
X
ˇ t+k+1 + (P̌t+k+1 − P̌t−1 )
(βθ)k Et ΘMC


+(1 − βθ)βθ
k=0
+∞
X
Pˇt∗ − P̌t−1 = ˇ t + (1 − βθ)πt + (1 − βθ)βθ
(1 − βθ)ΘMC (βθ)k (P̌t − P̌t−1 )
k=0
+∞
X
ˇ t+k+1 + (P̌t+k+1 − P̌t )
(βθ)k Et ΘMC


+(1 − βθ)βθ
k=0
∗
Pˇt∗ − P̌t−1 = ˇ t + πt + βθEt [P̌t+1
(1 − βθ)ΘMC − P̌t ]

27 )
Firm’s Problem cont.

I Use πt = (1 − θ)(P̌t∗ − P̌t−1 ) to get:

ˇt
π̌t = βEt π̌t+1 + κMC
(1−θ)(1−βθ)
κ= θ Θ.
I Iterate forward to find:
∞
X
π̌t = κ ˇs
β s−t Et MC
s=t

I Inflation is present value of future marginal costs

I Inflation should have low inertia in the model
I Inflation is aggregate consequence of purposeful optimizing
price-setting decisions of firms
28 )
Firm’s Problem cont.

I Relate MC to measures of aggregate economic activity:

ˇt
MC = (W̌t − P̌t ) − MPL ˇ t
= (ψ Y̌t + 1/η Lˇt ) − (Y̌t − Ľt )
 1/η + α  1 + 1/η
= ψ+ Y̌t − Žt ,
1−α 1−α

I ˇ t
Use “aggregate” production function to compute MPL
I FOC for labor supply to replace (W̌t − P̌t )

29 )
Firm’s Problem cont.

I Denote the level of output under flexible prices as Y N

I In a frictionless world: Pi = P, Yi = Y , θ = 0
σ N
I From FOC for optimal reset price we have 1 − σ−1 MC =0
⇒ hence MC N = σ−1σ = 1/µ

I Marginal cost in the frictionless world MC N fixed

I Replace output with the natural rate of output to get

ˇ N 1/η + α N 1 + 1/η ˇ
MC t = (ψ + )Y̌t − Zt
1−α 1−α

30 )
Firm’s Problem cont.

I ˇ N = 0 and hence:
MC N does not vary over time, MC

1 + 1/η
Y̌tN = Zˇt ⇒
(1 − α)ψ + 1/η + α
ˇt
 1/η + α  N
MC = ψ+ (Y̌t − Y̌t )
1−α
N
Y̌t − Y̌t : output gap (∆ btw actual and flex-price output)
1/η+α
I Let κ∗ = κ(ψ + 1−α )

I New Keynesian Phillips Curve (NKPC):

N
πt = βEt πt + κ∗ (Y̌t − Y̌t )

31 )
Firm’s Problem cont.

I NKPC key equation: links nominal and real variables

I Coefficient κ∗ intimately related to amount of real rigidity

I Lower values correspond to higher levels of real rigidity

I Modify Euler equation (3) to express it in terms of output gap:

N 1 N
(Y̌t − Y̌t ) = − (it − Et πt+1 − RtN ) + Et (Y̌t+1 − Y̌t+1 )
ψ
ψ(1+1/η)
RtN ≡ ψEt ∆Y̌t+1
N =
ψ(1−α)+1/η+α Et ∆Zt+1
N ) − 1 RN
Y̌tN = Et (Y̌t+1 ψ t

32 )
Firm’s Problem cont.

I This gives IS curve:

+∞
N 1 X N 1
(Y̌t − Y̌t ) = −Et ( (Rt+k − Rt+k )) = − (Rt − RtN ) + Et (Y̌t+1 − Y̌t+1
N
)
ψ ψ
k=0

Rt = it − Et πt+1 : real interest rate

N
I Output gap (Y̌t − Y̌t ) depends on path of future short rates

I Central bankers control only the short-term rate

I Can stabilize output if can promise path of interest rates

33 )
Firm’s Problem cont.

I To close the model, we have several options:

I Taylor rule: it = φπ πt + φy (Y̌t − Y̌tN ) + vt
vt : monetary policy shock
I Money demand: (Y̌t − Y̌tN ) − ζit = (M̌t − P̌t ) − Y̌tN
M̌t − P̌t : real money balances (or liquidity)
∆Mt : money shock

I The Taylor rule approximates central banks’ behavior well

I In summary, the basic New Keynesian model has 3 equation:
I IS curve
I NKPC curve
I Policy reaction function such as the Taylor rule

34 )
Interpretation and Solution

35 )
Interpretation and solution

I 3 equation New Keynesian macroeconomic model:

πt = βEt πt+1 + κ∗ X̌t (5)

1
X̌t = − (it − Et πt+1 − RtN ) + Et X̌t+1 (6)
ψ
it = φπ πt + φy X̌t + vt (7)

I Equation (5) NKPC (supply side)

I Equation (6) IS curve (demand side)

I Equation (7) describes monetary policy rule

36 )
Interpretation and solution

I Advantages compared to old Keynesian formulations:

I All curves are results of optimization problems

I Structural parameters: we can do policy experiments

I Fundamental role of forward looking behavior

37 )
Interpretation and solution

I Eliminate the interest rate equation to get:

   
X̌t X̌t+1
= AEt + B(ŘtN − vt ) (8)
πt πt+1

 
ψ 1 − βφπ
A = Ω (9)
ψκ∗ κ∗ + β(ψ + φy )
1
Ω = (10)
ψ + φ y + κ∗ φ π
 
1
B = Ω (11)
κ∗

38 )
Interpretation and solution

I Unique stable REE: # of stable eigenvalues = # of

predetermined variables:

   
X̌t+1 X̌t
Et = Π0 (12)
πt+1 πt

(Blanchard and Kahn (1980))

I Here: all variables are jump variables (non-predetermined)

⇒ all eigenvalues must be unstable
I Necessary and sufficient condition for this to hold is:

(1 − β)φy + κ∗ (φπ − 1) > 0 (13)

39 )
Interpretation and solution

I Monetary authority should respond sufficiently strongly

I Suppose that inflation increases permanently by ∆π:

∆i = φπ ∆π + φy ∆X
φy (1 − β)
= φπ ∆π + ∆π
κ∗
 φy (1 − β) 
= φπ + ∆π
κ∗

I Equation (13) is equivalent to:

φy (1 − β)
φπ + >1 (14)
κ∗

I Condition often called the (modified) Taylor principle

40 )
Interpretation and solution

I Taylor principle: higher inflation π > 0 ⇒ higher real rate

I Nominal rate increases so much that real rate increases

I Higher real interest rate depresses economic activity
I Output gap falls, inflation pressure cools down
I Policy keeps inflation in check

I Unique REE requires sufficiently aggressive stance on inflation

41 )
Interpretation and solution

I To study dynamics of this model, suppose:

vt = ρv vt−1 + vt (15)

(monetary policy shock)

I Innovation vt > 0 interpreted as monetary contraction

I Only predetermined variable is vt
I We guess a solution:

X̌t = cxv vt
πt = cπv vt

42 )
Interpretation and solution

I Use method of undetermined coefficients to find:

X̌t = −(1 − βρv )Γv vt

πt = −κ∗ Γv vt
Γv = {(1 − βρv ) [ψ(1 − ρv ) + φy ] + κ∗ [φπ − ρv ]}−1

I If Taylor principle satisfied: Γv > 0

I Expression for the nominal and real interest rate:

Rt = ψ(1 − βρv )(1 − ρv )Γv vt

it = Rt + Et πt+1 = [ψ(1 − βρv )(1 − ρv ) − ρv κ∗ ] Γv vt

I If ρv is sufficiently large: nominal rate can decrease

I Direct effect of vt offset by declines in inflation and output gap
43 )