Towards a New Keynesian Theory of the Price Level

56 Pages Posted: 14 Jul 2015

Multiple version iconThere are 2 versions of this paper

Date Written: July 10, 2015

Abstract

Modifying the standard New-Keynesian model to replace firms' full information and sticky prices with flexible prices and dispersed information, and imposing mild and plausible restrictions on the monetary authority's decision rule, produces the striking results that (i) there exists a unique and globally stable steady-state rate of inflation, despite the possibility of a lower bound on nominal interest rates; and (ii) in the vicinity of steady-state, the price level is determinate (and not just the rate of inflation), despite the central bank targeting inflation. The specification of firms' signal extraction problem under dispersed information removes the need to make use of Blanchard-Kahn conditions to solve the model, thereby removing the need to adhere to the Taylor principle and consequently circumventing the critique of Cochrane (2011). The model admits a determinate, stable solution with no role for sunspot shocks when the monetary authority responds by less than one-for-one to changes in expected inflation, including under an interest rate peg. An extension to include incomplete information on the part of the central bank permits the consideration of (rational) errors of judgement on the part of policymakers and provides a theoretical basis for inertial policymaking without interest rate smoothing, in support of Rudebusch (2002, 2006).

Keywords: D82, D84, E31, E52.

JEL Classification: New-Keynesian, indeterminacy, dispersed information, FTPL, Blanchard-Kahn

Suggested Citation

Barrdear, John, Towards a New Keynesian Theory of the Price Level (July 10, 2015). Bank of England Working Paper No. 532. Available at SSRN: https://ssrn.com/abstract=2630031 or http://dx.doi.org/10.2139/ssrn.2630031

John Barrdear (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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