Monetary Policy, Inflation, and the Business Cycle This page intentionally left blank Monetary Policy, Inflation, and the Business Cycle An Introduction to the New Keynesian Framework JordiGalí PrincetonUniversityPress PrincetonandOxford Copyright©2008byPrincetonUniversityPress PublishedbyPrincetonUniversityPress, 41WilliamStreet,Princeton,NewJersey08540 IntheUnitedKingdom:PrincetonUniversityPress, 6OxfordStreet,Woodstock,OxfordshireOX201TW AllRightsReserved LibraryofCongressCataloging-in-PublicationData Galí,Jordi,1961– Monetarypolicy,inflation,andthebusinesscycle:anintroduction totheNewKeynesianframework/JordiGalí. p. cm. Includesbibliographicalreferencesandindex. ISBN978-0-691-13316-4(hbk.:alk.paper) 1. Monetarypolicy. 2. Inflation(Finance). 3. Businesscycles. 4. Keynesianeconomics. I. Title. HG230.3.G352008 339.5'3—dc22 2007044381 BritishLibraryCataloging-in-PublicationDataisavailable ThisbookhasbeencomposedinTimesRomanbyWestchesterBookGroup. Printedonacid-freepaper.(cid:1)∞ press.princeton.edu PrintedintheUnitedStatesofAmerica 10 9 8 7 6 5 4 3 2 1 Alsmeuspares This page intentionally left blank Contents Preface ix 1 Introduction 1 2 AClassicalMonetaryModel 15 3 TheBasicNewKeynesianModel 41 4 MonetaryPolicyDesignintheBasicNewKeynesianModel 71 5 MonetaryPolicyTradeoffs:DiscretionversusCommitment 95 6 AModelwithStickyWagesandPrices 119 7 MonetaryPolicyandtheOpenEconomy 149 8 MainLessonsandSomeExtensions 185 Index 195 This page intentionally left blank Preface ThisbookbringstogethersomeofthelecturenotesthatIhavedevelopedoverthe pastfewyears,andwhichhavebeenthebasisforgraduatecoursesonmonetary economics taught at different institutions, including Universitat Pompeu Fabra (UPF), Massachusetts Institute of Technology (MIT), and the Swiss Doctoral Program at Gerzensee. The book’s main objective is to give an introduction to theNewKeynesianframeworkandsomeofitsapplications.Thatframeworkhas emergedastheworkhorsefortheanalysisofmonetarypolicyanditsimplications forinflation,economicfluctuations,andwelfare.Itconstitutesthebackboneofthe newgenerationofmedium-scalemodelsunderdevelopmentattheInternational MonetaryFund, theFederalReserveBoard, theEuropeanCentralBank(ECB), andmanyothercentralbanks.Ithasalsoprovidedthetheoreticalunderpinningsto theinflationstability-orientedstrategiesadoptedbythemajorityofcentralbanks intheindustrializedworld. Adefiningfeatureofthisbookistheuseofasinglereferencemodelthroughout the chapters. That benchmark framework, which I refer to as the “basic New Keynesianmodel,”isdevelopedinchapter3.Itfeaturesmonopolisticcompetition andstaggeredpricesettingingoodsmarkets,coexistingwithperfectlycompetitive labor markets. The “classical model” introduced in chapter 2, characterized by perfect competition in goods markets and flexible prices, can be viewed as a limiting case of the benchmark model when both the degree of price stickiness andfirms’marketpowervanish.Thediscussionoftheempiricalshortcomingsof theclassicalmonetarymodelprovidesthemotivationforthedevelopmentofthe NewKeynesianmodel,asdiscussedintheintroductorychapter. The implications for monetary policy of the basic New Keynesian model, includingthedesirabilityofinflationtargeting,areanalyzedinchapter4.Eachof thesubsequentchaptersthenbuildsonthebasicmodelandanalyzesanextension of that model along some specific dimension. Once the reader has grasped the contents of chapters 1 through 4, each subsequent chapter can be read indepen- dently,andinanyorder.Thus,chapter5introducesapolicytradeoffintheform of an exogenous cost-push shock that serves as the basis for a discussion of the differencesbetweentheoptimalpolicywithandwithoutcommitment.Chapter6 extendstheassumptionofnominalrigiditiestothelabormarketandexaminesthe