Real Wage Rigidities and the New Keynesian Model
Olivier J. Blanchard
National Bureau of Economic Research (NBER); Peter G. Peterson Institute for International Economics
Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI); Massachusetts Institute of Technology (MIT) - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
October 31, 2005
MIT Department of Economics Working Paper No. 05-28
FRB Boston Working Paper No. 05-14
Most central banks perceive a trade-off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade-off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare-relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence, is due to a special feature of the model: the absence of non trivial real
We focus on one such real imperfection, namely, real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade-off between stabilizing inflation and stabilizing the welfare-relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interpretation for the dynamic inflation - unemployment relation found in the data.
Number of Pages in PDF File: 37
Keywords: oil price shocks, inflation targeting, monetary policy, inflation inertia
JEL Classification: E32, E50
Date posted: November 7, 2005
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