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Real Wage Rigidities and the New Keynesian Model

37 Pages Posted: 7 Nov 2005  

Olivier J. Blanchard

National Bureau of Economic Research (NBER); Peter G. Peterson Institute for International Economics

Jordi Galí

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)

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Date Written: October 31, 2005

Abstract

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
imperfections.

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.

Keywords: oil price shocks, inflation targeting, monetary policy, inflation inertia

JEL Classification: E32, E50

Suggested Citation

Blanchard, Olivier J. and Galí, Jordi, Real Wage Rigidities and the New Keynesian Model (October 31, 2005). MIT Department of Economics Working Paper No. 05-28; FRB Boston Working Paper No. 05-14. Available at SSRN: https://ssrn.com/abstract=842285 or http://dx.doi.org/10.2139/ssrn.842285

Olivier J. Blanchard (Contact Author)

National Bureau of Economic Research (NBER) ( email )

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Peter G. Peterson Institute for International Economics ( email )

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Washington, DC 20036
United States

Jordi Gali

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI) ( email )

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain
+34 93 542 2754 (Phone)
+34 93 542 1746 (Fax)

HOME PAGE: http://www.econ.upf.es/~gali

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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United States

Centre for Economic Policy Research (CEPR)

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London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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