Real Wage Rigidities and the New Keynesian Model

37 Pages Posted: 24 Jan 2006 Last revised: 20 Feb 2006

See all articles by Olivier J. Blanchard

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)

Multiple version iconThere are 3 versions of this paper

Date Written: November 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.

Suggested Citation

Blanchard, Olivier J. and Gali, Jordi, Real Wage Rigidities and the New Keynesian Model (November 2005). NBER Working Paper No. w11806. Available at SSRN: https://ssrn.com/abstract=851715

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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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 )

50 Memorial Drive
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United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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