Lecture 05 - NKM

By Chiara Fratto

Reference:
GALI, J. [2006]: Monetary Policy, Inflation, and the Business Cycle, Chapter 3

I. Flexible Prices

A. Structure of the economy

The composite consumption good is made of a continuum of varieties of differentiated

goods, each produced by a monopolistically competitive firm. There is a continuum of
such firms, between 0 and 1; firm j produces the variety Cj , with a production function
using labor only as input
There is a continuum of households indexed by i [0, 1]. They provide homogeneous labor
to firms.

B. Household

Household i solves:

" 1+
#
1
X Ct+k Nt+k
(1) max E0 k + log(Mt+k /Pt+k )
k=0
1 1+

s.t. the budget constraint in real terms

 
Mt Bt Wt Mt1 Bt1
(2) Ct + + = Nt + + (1 + it1 ) + Qt
Pt Pt Pt Pt Pt

Fratto: Department of Economics, University of Chicago, 1126 East 59th Street, Chicago, IL 60637,
U.S.A, cfratto@uchicago.edu.
1
In these expressions,Ct is the composite consumption good in real terms, it is the nominal
interest rate, Mt is holding of money at the end of period t (that is, after consumption Ct
has been decided), Bt is the the nominal value of holdings at the end of period t of one
-period bonds, and Qt is profits (I have omitted the sub-indices i for simplicity).
The elasticity of substitution between two varieties is constant at , and the composite
good is defined as

Z 1 1
 1

(3) Ct = Cj t dj
0

1
Z 1  1
(4) Pt = Pjt1 dj
0

where Cjt is the j-th variety of goods, Pjt its price, and Pt is the price of the composite
good.
We solve this model in two stages.

For a given level of total consumption, Ct , how does the household allocates it across
varieties, {Cjt }

Find the equilibrium conditions for Ct , Bt , Mt , Nt .

First stage:
Z 1
(5) min Pjt Cjt dj
Cjt 0

Z 1 1
 1

(6) s.t. Cj t dj Ct
0

It is easy to show that the optimal consumption of the variety j is (see Problem set 6)

 
Pjt
(7) Cjt = Ct
Pt
hence the price elasticity of demand for good j is .

Second stage: maximize utility subject to budget constraint with respect to Ct , Bt , Mt , Nt .

Optimality conditions for the household:
  
Pt
(8) 1 = (1 + it )Et Ct Ct+1
Pt+1
Ct it
(9) =
(Mt /Pt ) 1 + it
Nt Wt
(10) =
Ct Pt
 
Mt Bt Wt Mt1 Bt1
(11) Ct + + = Nt + + (1 + it1 ) + Qt
Pt Pt Pt Pt Pt

C. Firm

Production function: The composite consumption good is made of a continuum of varieties

of differentiated goods, each produced by a monopolistically competitive firm. There is
a continuum of such firms, between 0 and 1; firm j produces the variety Cj , with a
production function using labor only as input

(12) Yjt = At Njt

where At is an aggregate productivity shock.

Maximize profits subject to demand for good variety:

(13) max Pjt Yjt [Wt (1 )]Nj,t

Pjt

(14) s.t.Yjt = At Njt

 
Pjt
(15) Yjt = Yt
Pt
    
Pjt Pjt Yt
(16) max Pjt Yt [Wt (1 )]
Pjt Pt Pt At

Solution: firms set price equal to a markup over the marginal cost.

Wt (1 )
(17) Pjt = = Pt
1 At

Firms set the price at the same level.

D. Loglinearization and Equilibrium with flexible prices

In this model, dealing with loglinearized equations is much easier than using the nonlinear
ones.
We now log-linearize (8) around a steady state with constant inflation and consumption
growth. Write (8) as:

(18) 1 = Et {exp [log + log(1 + it ) (log Ct+1 log Ct ) t+1 ]}

where t+1 log Pt+1 log Pt is the inflation rate. Also, 1/(1 + ), hence log() =
log(1 + ) ; finally log(1 + it ) it .Hence the above equation becomes

1 = Et {exp [it (log Ct+1 log Ct ) t+1 ]}

In a steady state with constant inflation rate ss and no consumption growth we must
have

(19) iss = ss +

A first order Taylor expansion of exp [it (log Ct+1 log Ct ) t+1 ] around the
steady state with constant inflation and zero consumption growth thus gives

exp [it (log Ct+1 log Ct ) t+1 ] = 1 + [(it iss ) (t+1 ss ) (ct+1 ct )]
Plugging this back into (18), using (19) to replace iss , and rearranging gives:

1
(20) ct = [it Et (t+1 ) ] + Et (ct+1 )

or using the Fisher equation: rt = it Et t+1

1
(21) Et (ct+1 ) ct = (rt )

Thus, the slope of the consumption and income paths depend on the difference between
the real interest rate and the rate of time preference. The real interest rate is the price of
consumption in t relative to consumption in t+1; when the real interest rate increases, the
price of todays consumption increases; correspondingly, the consumption path becomes
steeper (given Et (ct+1 ), ct falls). How strong this effect is depends on 1/, the coefficient of
intertemporal substitution. If it is large (high intertemporal substitution), a small change
in the real interest rate translates in a large change in the slope of the consumption
path. In the extreme case, if it is infinite, the consumer is indifferent when she consumes,
and is willing to transfer all her consumption to the period where it costs less. At the
other extreme, if it is close to 0, this means that the consumer does not like to do
intertemporal substitution, and prefers to smooth consumption perfectly (i.e., always to
set ct = Et (ct+1 )).

Imposing the market clearing condition yt = ct

1
(22) yt = [it Et (t+1 ) ] + Et (yt+1 )

1
(23) yt = [rt ] + Et (yt+1 )

Loglinearizing also (10):

(24) wt pt = nt + yt
The equation for prices from the firm:

(25) pt = wt at +

Combining the two and the production function:

(26) nt + yt = at +

(27) ( + )yt at = at +
1+
(28) yt = + at
+ +

This is the level of output under flexible prices with monopolistic competition.

From (22), replacing yt with the expression above and similarly for Et yt+1 , the real interest
rate under flexible prices is

1+
(29) rt = + (Et at+1 at )
+

Notice that both output and the real interest rate are affected by the productivity shock,
but they are independent of money supply. Money neutrality.

We call them the natural levels of output and real interest rate. Note that, in the absence
of shocks, all the variables in the flexible price equilibrium are constant.

The efficient level of output is the level of output that would obtain under flexible prices,
perfect competition (i.e. = 0), and no distortionary taxation of employment (i.e. = 0).

The natural level of output is efficient if the subsidy is set at the markup, i.e. if = .

E. Indeterminacy with an exogenous interest rate rule

The model is not closed. There is one equation missing: a rule for the nominal interest
rate.

Suppose that it follows the exogenous path {it } with mean (this is consistent with
ss = 0 and css = 0). From the Fisher equation one gets

(30) Et t+1 = it rt

where it is given and rt is pinned down by real factors. Hence, actual inflation (as opposed
to its expectation) is not pinned down: in particular, any process satisfying

(31) t+1 = it rt + t+1

such that Et t+1 = 0 is consistent with the equilibrium. Hence, the inflation rate (and,
given the initial price level, the price level as well) is indeterminate. t+1 is a sunspot
shock: its realizations are validated in equilibrium

F. Optimal monetary policy with flexible prices

The social optimum is found by solving the social planner problem

X Mt+k
(32) max E0 k U (Ct+k , Nt+k , )
k=0
Pt+k

s.t.

(33) Ct = At Nt

i.e. the resource constraint of the whole economy. Derive the aggregate resource constraint
from the households budget constraint and market clearing on bonds and equation for
firms profits.

In fact, note that this is a closed economy, and in the aggregate there is no way to transfer
resources from one period to another; hence, the economy must consume all it produces.
Hence, the social optimum is found by solving a sequence of static problems. By directly
replacing Ct+k with At+k Nt+k , the FOC with respect to monetary balances is

(34) Um = 0

The intuition for the second FOC is clear: the social opportunity cost of printing money is
0; at an optimum, the marginal utility from money must be equal to the social opportunity
cost.

In a decentralized equilibrium, recall that

Um it
(35) =
UC 1 + it

hence the decentralized equilibrium attains the social optimum if it = 0, the Friedman
rule.

From the Fisher equation

(36) it = rt + Et t+1

in steady state, rss = . Hence, in steady state the Friedman rule implies

(37) ss =

i.e. the inflation rate should be negative and equal to the opposite of the rate of time
preference.

But we know that exogenous interest rate rules lead to indeterminate solutions. How can
one avoid indeterminacy?
 II. Sticky Prices

The households side is unchanged. Instead, now we assume that firms cannot always
reset their price. This price setting mechanism is called Calvo pricing.

A. Firm

Now assume that firms can reset their price with probability 1 . Each period a fraction
1 of firms reset their price. Firms who reset their price at time t are all going to set
it to the same level, Pt . Call St the set of firms that do not reoptimize in period t.

hZ 1 1
i 1 hZ 1
i 1
(38) Pt = 1
Pj,t1 dj = 1
Pj,t1 dj + (1 )Pt1 =
0 St
h i 1
1 1 1
(39) Pt1 + (1 )Pt

the last equality comes from the fact that the probability of being able to reset the price
is exogenous.

No need to derive this. The loglinearized equation is the following:

(40) t = (1 )(pt pt1 )

where t log(Pt ) log(Pt1 ).

The firms problem can be rewritten as

X
min Et k [pj,t+k pft+k
lex 2
]
{pj,t+k }
k=0

where pft+k
lex
is the price that would prevail in the absence of any restrictions on price
adjustment and pft+k
lex
= + mcnt+k (the price that would prevail in the absence of nominal
rigidities would be a markup over the nominal marginal cost.)

(41)
X
Et k [pj,t+k pft+k
lex 2
] = [pj,t pft lex ]2 + Et [pj,t pft+1
lex 2
] + (1 )Et [pj,t+1 pft+1
lex 2
]+
k=0

(42) +2 Et 2 [pj,t pft+2 ] + ((1 ) + (1 )2 )Et 2 [pj,t+2 pft+1

lex 2 lex 2
] + ....

Collect the terms in pj,t ,

X
min

Et k k [pj,t pft+k
lex 2
]
pj,t
k=0

FOC:

X
X
(43) pj,t k k
= k k Et pft+k
lex

k=0 k=0

X
(44) pj,t = (1 ) k k Et pft+k
lex

k=0

X
(45) pj,t = + (1 ) k k Et mcnt+k
k=0

It can be shown that you car rewrite this combined with equation 40 as (no need to derive
it):

(46) t = Et t+1 + mct

X
(47) t = k Et mct+k
k=0

where is the percentage deviation of the real marginal cost from its steady state (M Css =
(1)(1)
log() ) and
.
W (1)
The New Keynesian Phillips curve The real marginal cost is given by M C = AP

(48) mct = log(M Ct ) log(M Css ) = w p a

Then, use the intratemporal optimality condition between labor and consumption for the
household, combined with the market clearing condition for goods (Y = C) to get

(49) mct = ( + )yt (1 + )at +

h 1+ i
(50) = ( + ) yt at =
+ +
h i
f lex
(51) = ( + ) yt yt

h i
f lex
(52) t = Et t+1 + ( + ) yt yt

(53) t = Et t+1 + xt

(1)(1)
We call xt the output gap and
( + ) > 0.

Implications

1) Inflation does not depend on output. It depends on the output gap, the deviation
of output from its natural level (the level under flexible prices).

2) The current level of inflation depends on expectations of future inflation.

3) The term Et t+1 incorporates expectations of future marginal costs.

The dynamic IS equation

Lets rewrite the Euler equation in terms of output gap. Add and subtract ytf lex Et yt+1
f lex
.

1
(54) xt = [it Et t+1 ] + Et xt+1 + t

where

1+
(55) t ytf lex Et yt+1
f lex
== (at Et at+1 )
+
but also

1+
(56) rtf lex = + (Et at+1 at )
+
1+ 1
(57) (at Et at+1 ) = (rtf lex )
+

Plugging it back in

1
(58) t = (rtf lex )

And the Euler equation can be written as

1
(59) xt = [rt rtf lex ] + Et xt+1

Implications:

1) real variables are determined jointly with nominal variables.

2) Monetary policy affects real economy if it affects the real interest rate relative to its
natural level.

B. Equilibrium with an exogenous interest rule

We are going to show that the equilibrium with exogenous interest rule is indeterminate
in this case as well (there is an infinite number of solutions consistent with the equilibrium
conditions.)
Assume that it = rtf lex . Then,

1+
(60) ift lex = + (Et at+1 at )
+

Plug it in the IS dynamic equation and use the Fisher equation:

1
(61) xt = Et t+1 + Et xt+1

System of equations:

1
xt 1 E x
(62) = t t+1
t + Et t+1

x Ex
(63) t = M t t+1
t Et t+1

The eigenvalues of the matrix solve the equation

(64) det(M I) = (1 )( + ) = 0

(65) 2 a1 + a2 = 0
+ +
(66) a1 = >0

(67) a2 = > 0

where remember that the roots 1 and 2 are such that 1 2 = a2 and 1 + 2 = a1 . It
can be shown that the conditions for both eigenvalues to be inside the unit circle are

(68) |a2 | < 1

(69) |a1 | < 1 + a2

The first condition is satisfied trivially. The second requires that
< 0, which is not
satisfied, since both and are positive.

So, again we get to the same result as in the case with flexible prices: an exogenous
rule on interest rate introduces indeterminacy (a continuum of solutions) and there is the
possibility of sunspot equilibria as before.

Suppose that for some exogenous reason Et t+1 increases. Because it does not respond,
the real interest rate rt falls. Using the IS curve, it follows that xt increases. From
the Phillips curve, inflation increases, thus validating the initial increase in inflationary
expectations.
 C. Equilibrium with a Taylor rule

Suppose that the monetary policy rule is given by

(70) it = rtf lex + t

This is called Taylor rule or at least one formulation.

Note: its original formulation was

(71) it = rtf lex + (t t ) + x xt

where t is some inflation target. This was introduced by Taylor in 1993. In its initial
formulation it was a descriptive rule, aimed at describing ex post the behavior of the
central bank. Later it was used with a normative function, indicating how a central bank
should operate.

We can use equation 70, substitute it in the IS curve and find the conditions for the
existence of an equilibrium.

x 1 1 Ex
(72) t = t t+1
t + + Et t+1

t , xt is a solution. For it to be the only stationary solution, it has to be that both

eigenvalues are inside the unit circle.

Compute the eigenvalues and show that the condition for both eigenvalues is that > 1.

This is called Taylor principle. It says that, to ensure price stability and uniqueness, mon-
etary policy should react to deviation of inflation from its optimal point with sufficient
strength.
 III. Appendix

A. Optimal conditions for the first stage of the household problem. Derivation of the
demand for good varieties.

You do not need to study this. This is merely for those who do not trust me and want to
see the algebra.
The problem is
Z 1
(73) min Pjt Cjt dj
{Cjt } 0

Z 1 1
 1

(74) s.t. Cj t dj Ct
0

Let t be the Lagrange multiplier. Write the Lagrangean for the problem:

(Z )
Z 1 1 1
 1

L= Pjt Cjt dj t Cj t dj Ct
0 0

The solution for unconstrained optimization of the Lagrangean function corresponds to

the solution of the the original (constrained) problem. The first order condition for a
generic Ckt is

1
Z 1  1
L 1

1
(75) = Pkt t Cj t dj Ckt = 0
Ckt 0

i.e.
 
Pkt
(76) Ckt = Ct
t

This condition holds for every k.

But then using the definition of Ct above,


"  # 1

1
Z 1  1 Z 1
1
Pjt
(77) Ct = Cj t dj = Ct dj
0 0 t

 Z 1  1
1
(78) = Ct Pjt1 dj
t 0

which gives

Z 1  1
(79) t = Pjt1 dj
0
(80) = Pt

Hence

(81) t = Pt

and therefore
 
Pjt
(82) Cjt = Ct
Pt