New Keynesian Model

Martin Martinez

Lambda Group

2023

Martin Martinez (Lambda Group) NK 2023 1 / 25

The RBC Model - Critiques

Last class we reviewed the Real Business Cycle Model.

Dynamic and stochastic version of neoclassical growth model with
capital and endogenous labor supply.
Complete markets, no externalities.
Calibrate model, feed in shocks based on Solow residual.
Model fit surprisingly good.
Today, we are going to critique the RBC model and search for ways
forward.
RBC will be starting point for New Keynesian model.

Martin Martinez (Lambda Group) NK 2023 2 / 25

Early Criticism

1 Are the parameters right?

Particular focus on labor supply elasticity being high.
2 What are the shocks?
Where do they come from?
Why don’t we read about them?
Can technology growth be so irregular?
Does technology really regress?
Other shocks matter – financial, for instance.
3 What about prices? “Price-free economics.”
1 Is some on prices, and does okay. But hard to measure.
4 More philosophical. Keynesian view is next.

Martin Martinez (Lambda Group) NK 2023 3 / 25

What Parameters Matter for Empirical Success?

1 A highly persistent and sufficiently volatile technology shock.

Need to match volatility and persistence of output.
2 Sufficiently elastic labor supply.
Need to match fluctuations in aggregate hours.
3 Reasonable steady state shares of consumption and investment in
output.
Need investment share low to match that investment is more volatile
than output and consumption is smoother than output

Martin Martinez (Lambda Group) NK 2023 4 / 25

NEK: Outline

1 The Baseline New Keynesian Model

2 Nonlinear Equations: Intuition
3 Log-Linearized Version
4 The Three Equation Model
5 Calibrated Model: Impulse Responses and Intuition

Martin Martinez (Lambda Group) NK 2023 5 / 25

NEK: Roadmap

Three “blocks” to the model:

1 Household: Same as in money model.

Optimality conditions generate “Dynamic IS” curve that gives
relationship between output and real interest rate.
2 Firms: Same as imperfect competition model, with addition of
persistent nominal rigidity for intermediate producers.
Generates a “New Keynesian Phillips Curve,” a forward-looking,
expectations-augmented Phillips curve.
3 Monetary authority’s nominal interest rate rule closes model.

Martin Martinez (Lambda Group) NK 2023 6 / 25

NEK: Household Problems
Maximize its consumption among all goods subject to a fixed expenditure.
A representative infinitely-lived household, seeking to maximize:

∞
1 1
Nt1+φ
X
V = E0 β t U(Ct , Nt ) , U(Ct , Nt ) = Ct1−σ −
t=0
1−σ 1+φ

where Ct is a consumption index given by

Z 1 ϵ
 ϵ−1
ϵ−1
Ct = Ct (i) ϵ di (1)
0

with Ct (i) representing the quantity of good i consumed by the household

in period t.

Martin Martinez (Lambda Group) NK 2023 7 / 25

Note that we assume the existence of a continuum of goods represented
by the interval [0, 1]. The period budget constraint now takes the form

Z 1
Pt (i)Ct (i)di + Qt Bt ≤ Bt−1 + Wt Nt + Tt for t = 0, 1, 2, ....
0

Pt (i) : Price of good i

Z 1
Pt (i)Ct (i)di = Pt Ct (2)
0

STEPS:
1 Intertemporal choice ⇔ Ct∗
2 Intratemporal choice ⇔ Ct (i)∗

Martin Martinez (Lambda Group) NK 2023 8 / 25

Intertemporal Choice
Maximization Problem:
∞
1 1
 
N 1+φ
X
t
MaxCt ,Nt ,Bt V = E0 β Ct1−σ −
t=0
1−σ 1+φ t

s.t. Pt Ct + Qt Bt ≤ Bt−1 + Wt Nt + Tt

Lagragian:
P∞ h t  1 1−σ 1 1+φ

L = E0 t=0 β 1−σ C t − 1+φ N t +λt (Bt−1 + Wt Nt + Tt
−Pt Ct − Qt Bt )]

1 Labor Supply:
Ct−σ Wt = Ntφ Pt (3)
2 Euler Equation:
−σ
Ct−σ
" #
Ct+1
Qt = βEt (4)
Pt Pt+1
Martin Martinez (Lambda Group) NK 2023 9 / 25
Intratemporal Choice
The household now must decide how to allocate its consumption expenditures
among different goods. This requires that the consumption index Ct be
R1
maximized for any given level of expenditures 0 Pt (i)Ct (i)di.
Maximization Problem:
ϵ
Z 1  ϵ−1 Z 1
ϵ−1
MaxCt (i) Ct = Ct (i) ϵ di s.t. Pt Ct = Pt (i)Ct (i)di
0 0

Lagragian:
R ϵ
 ϵ−1 h i
1 ϵ−1 R1
L= 0
Ct (i) ϵ di + λt Pt Ct − 0
Pt (i)Ct (i)di

1 Aggregate Price level:

1
Z 1  1−ϵ
1−ϵ
Pt = Pt (i) di (5)
0
2 Dixit and Stilitz’s Demand:
 −ϵ
Pt (i)
Ct (i) = Ct , ∀i ∈ [0, 1] (6)
Pt
Martin Martinez (Lambda Group) NK 2023 10 / 25
Summary of HH equations:
1 Labor supply: eq.(3)
Ct−σ Wt = Ntφ Pt
2 Euler Equation: eq.(4)
" #
−σ
Ct−σ Ct+1
Qt = βEt
Pt Pt+1
3 Consumption Index: eq.(1)
ϵ
Z 1  ϵ−1
ϵ−1
Ct = Ct (i) ϵ di
0
4 Aggregate price level: eq.(5)
1
Z 1  1−ϵ
1−ϵ
Pt = Pt (i) di
0
5 Demand of goods: eq.(6)
 −ϵ
Pt (i)
C (i)t = Ct
Pt
Martin Martinez (Lambda Group) NK 2023 11 / 25
NEK: FIRM PROBLEM
Each firm, i ∈ [0, 1], produces a differentiated good, but they all use an
identical technology, represented by the production function

Yt (i) = At Nt (i)1−α (7)

To choose the optimum level of N(i)t , we must maximize:

Ω = Pt (i)Yt (i) − Wt Nt (i)

1 Labor Demand:

Yt (i)
Wt = (1 − α)Pt (i)At Nt (i)−α = (1 − α)Pt (i) (8)
Nt (i)

What about Pt (i) ? firms are under monopolistic competition!!

Martin Martinez (Lambda Group) NK 2023 12 / 25

Aggregate Price Dynamics - Calvo (1983)
Each period a measure 1 − θ of producers reset their prices, while a fraction θ
keep their prices unchanged.

1 Choose the optimum price with probability ”1 − θ”: P(i)t = Pt∗

2 Remain the last price with probability ”θ”: P(i)t = Pt−1

From eq.(5):

Z 1 1
 1−ϵ
1−ϵ
Pt = Pt (i) di
0
Z θ Z 1
Pt1−ϵ = 1−ϵ
Pt−1 di + Pt∗1−ϵ di
0 θ
1−ϵ
Pt1−ϵ = Pt−1 θ + Pt∗1−ϵ (1 − θ) (9)

Martin Martinez (Lambda Group) NK 2023 13 / 25

Optimal Price Setting
A firm reoptimazing in period t will choose the price Pt∗ :

Total Cost:

TC (i) = Wt Nt (i) (10)

Recall eq.(7) and rearranging it in order to get an expression of Nt :
1
Yt (i)
  1−α
Nt (i) = (11)
At
Replacing this equation into total cost
1
Yt (i)
  1−α
TCt (i) = Wt
At
Marginal Cost:
∂TCt (i) 1 Nt (i)α
MCt (i) = = Wt (12)
∂Yt (i) (1 − α) At

(1 − α)MCt (i)Yt (i) = Wt Nt (i) (13)

Plugging eq.(13) into eq.(10) in order to get a function of total cost in terms of output
units.

TCt (i) = (1 − α)MCt (i)Yt (i) = Ψt (Yt )

Martin Martinez (Lambda Group) NK 2023 14 / 25
 h i
UC (Ct+s )
The Stochastic Discount Factor: is defined as:Qt+s = β s Et UC (Ct )
Recall the euler equation eq.(4):
" #
−σ
Ct−σ Ct+1
Qt = βEt
Pt Pt+1

the stochastic discount factor at time t for k periods ahead is:

" #
−σ
k
Ct+k Pt
Qt,t+k = β Et (14)
Pt+k Ct−σ

Martin Martinez (Lambda Group) NK 2023 15 / 25

Firm’s Maximization Problem

(∞ )
X  ∗
k

MaxPt∗ Ω = Et θ Qt,t+k Pt Yt+k/t (i) − TCt+k/t (i) (15)
k=0

s.t. −ϵ
Pt∗

Yt+k/t (i) = Yt+k (16)
Pt+k
FOC: after some algebra
(∞  )
∂Ω X
k
  Pt∗ r ϵ Y
= Et θ Qt,t+k Yt+k/t (i) − (1 − α)MCt+k/t (i) t−1,t+k =0
∂Pt∗ Pt−1 (ϵ − 1)
k=0
(17)

Martin Martinez (Lambda Group) NK 2023 16 / 25

Special case: No price frictions (θ = 0) the previous condition collapses
to the familiar optimal price setting condition under flexible prices
ϵ
Pt∗ = (1 − α)MCt+k/t (i)
(ϵ − 1)

1
 
Pt∗ = 1− (1 − α)MCt+k/t (i)
ϵ−1
if
ϵ > 1 =⇒ Pt∗ > (1 − α)MCt+k/t (i)
ϵ → ∞ =⇒ Pt∗ = (1 − α)MCt+k/t (i)

Martin Martinez (Lambda Group) NK 2023 17 / 25

Summary of Firm equations:
1 Production Function: eq.(7)
Yt (i) = At Nt (i)1−α
2 Labor demand: eq.(8)
Wt = (1 − α)Pt (i)At Nt (i)−α
Yt (i)
Wt = (1 − α)Pt (i)
Nt (i)
3 Marginal Cost: eq.(12)
1 Nt (i)α
MCt (i) = Wt
(1 − α) At
4 Aggregate price dynamics: eq.(9)
Pt1−ϵ = Pt−1
1−ϵ
θ + Pt∗1−ϵ (1 − θ)

5 The stochastic discount factor: eq.(14)

 −σ 
Ct+k Pt
Qt,t+k = βEt
Pt+k Ct−σ
6 Optimal price stting condition: eq.(17)
(∞ )
h Pt∗
i
∂Ω ϵ
X  Y
k r
= Et θ Qt,t+k Yt+k/t (i) − (1 − α)MCt+k/t (i) t−1,t+k =0
∂Pt∗ Pt−1 (ϵ − 1)
k=0

Martin Martinez (Lambda Group) NK 2023 18 / 25

Log Linear Model
1 Households:
Labor supply: eq.(3)
wt − pt = φnt + σct (18)
Euler Equation: eq.(4)
1  
ct = Et ct+1 − it − Et πt,t+1 − ρ where ρ = −logβ (19)
σ
2 Firms:
Production Function: eq.(7)
yt (i) = at + (1 − α)nt (i) (20)
Labor demand: eq.(8)
wt − pt = yt (i) − nt (i) + log(1 − α) (21)
Marginal Cost: eq.(12)
r
mct (i) = αnt (i) + wt − at − pt − log(1 − α) (22)
Aggregate price dynamics: eq.(9)
∗
πt = (1 − θ)(pt − pt−1 ) where πt = pt − pt−1 (23)

The stochastic discount factor: eq.(14)

qt,t+k = −σ Et ct+k − ct − Et πt,t+k + klogβ (24)

Optimal price setting condition: eq.(17)

∞

X 
∗ k r
pt − pt−1 = (1 − θβ) (θβ) Et mct+k/t (i) + pt+k − pt−1 (25)

k=0

Martin Martinez (Lambda Group) NK 2023 19 / 25

Benchmark: Equlibrium w/o Frictions (log-linear
version)
1 Market Clearing: the superscript n implies an equilibrium without
frictions.
ytn (i) = ctn (i)
2 Labor Market (eq.(18)=eq.(21))

Labor Demand = Labor Supply

1−σ n
nt (i) = y (i) (26)
1+φ t
3 Production Function eq.(20)

ytn (i) = at + (1 − α)nt (i)

(1 + φ)at
ytn (i) = (27)
φ + α + σ(1 − α)
Martin Martinez (Lambda Group) NK 2023 20 / 25
The Phillips Curve
Solving the Optimal Price condition and taking into account that
yet = yt (i) − ytn (i) , we get:

σ(1 − α) + α + φ
 
πt = λ yet + βEt πt+1
1−α
πt = κyet + βEt πt+1 (28)

where
σ(1 − α) + α + φ
 
κ=λ
1−α
[1 − θβ] (1 − θ)
λ= Θ
θ
1−α
Θ=
1 − α + αϵ

Equation (28) is the new Keynesian Phillips curve.

Martin Martinez (Lambda Group) NK 2023 21 / 25
The IS Curve
Closed economy:
Yt = Ct

and in its log-linear version

yt = ct

Using this consition into the log-linear euler equation eq.(19) (in its
natural level-without frictions)
1hn i
ytn = Et yt+1
n n

− it − Et πt,t+1 −ρ (29)
σ

Using Fisher equation:

rtn = itn − Et πt+1
n

and taking into account yet = yt (i) − ytn (i), we get our dynamic IS equation
1
it − πt,t+1 − rtn

yet = Et {yet+1 } − (30)
σ
Martin Martinez (Lambda Group) NK 2023 22 / 25
Three main equations

The Dynamic IS

1
yet = Et {yet+1 } − [it − πt,t+1 − rtn ]
σ

The New Keynesian Phillips Curve

πt = κyet + βEt πt+1

A Monetary Policy Rule

it = ρ + ϕπ πt + ϕy yet + υt

Martin Martinez (Lambda Group) NK 2023 23 / 25

Calibrated Model-Supply Shock

Martin Martinez (Lambda Group) NK 2023 24 / 25

Calibrated Model-Demand Shock

Martin Martinez (Lambda Group) NK 2023 25 / 25