Chapter 4

The dynamic new-keynesian model

Recent years have seen an explosion of models in which there are nominal rigidities; these
models have nested the RBC model as a special case.
At least since Keynes, it has been thought that in order to have real effects from monetary
actions, it is key to have some degree of nominal rigidity. The question we want to explore
is: can a model based on microfoundations based on these features describe some important
features of the link between monetary actions and the business cycle?
What do we need in order to get nominal rigidities in the traditional, dynamic general
equilibrium model? Well, we need some form of pricing power, for instance coming from
monopolistic competition, and therefore some heterogeneity among goods.
The main actors of the DNK model are:
agents/mkts Þnal good intermediate labor proÞt money bonds
Household −P c WL P F M−1 − M + P T RB−1 − B =0
R1
Þnal Þrm PY − 0 Pj Yj dj =0
R1
interm. Þrms 0
Pj Yj dj −W L −P F =0
Govt M − M−1 − P T =0
equilibrium =0 =0 =0 =0 =0 =0

• households: make consumption and labor supply decisions, demand money and bonds

• Þnal good Þrms: produce Þnal goods Yt from intermediate goods Yjt

• intermediate good Þrm: use labor to produce intermediate goods Yjt . Over each of this
goods they have monopoly power. Demand labor. Can set price of good Yj

• government: runs monetary policy.

4.1 Households
There is a continuum of inÞnitely-lived individuals, whose total is normalized to 1. They
choose consumption ct , labor Lt , money Mt and bonds Bt in order to maximize:

31
32 CHAPTER 4. THE DYNAMIC NEW-KEYNESIAN MODEL

X
∞ µ ¶
c1−ρ 1 Mt
E0 β t t
− (Lt )η + χ ln
t=0
1−ρ η Pt

where E0 denotes the expectation operator conditional on time 0 information, β is the

discount factor, subject to:

Bt Rt−1 Wt Mt − Mt−1
ct + = Bt−1 + Lt + Ft − + Tt
Pt Pt Pt Pt

where the wage is wt ≡ Wt /Pt , and bonds pay the predetermined nominal interest rate Rt−1 ;
Ft denotes lump-sum dividends received from ownership of intermediate goods Þrms (whose
problems are described below); the last three terms indicate net transfers from the central
bank that are Þnanced by printing money.
Let Πt ≡ Pt /Pt−1 denote the gross rate of inßation. Solving this problem yields Þrst
order conditions for consumption/saving, labour supply and money demand:
µ ¶
1 Rt
= βEt (Euler)
cρt Πt+1 cρt+1
wt
ρ = Lη−1
t (LS)
ct
µ ¶
1 1 1 χ
ρ = Et β ρ + (MD)
ct Πt+1 ct+1 mt

where mt are real balances (Mt /Pt ).

4.2 Final-goods Þrm

There is a Þnal-goods sector where a representative Þrm produces the Þnal good Yt using
intermediate goods Yjt . Total Þnal goods are given by the CES aggregator of the different
quantities of intermediate goods produced:
µZ 1 ¶ ε−1
ε
ε−1
Yt = Yjt dj
ε

where ε > 1.
The Þrm buys inputs Yjt and produces the Þnal good in order to maximize proÞts, taking
Pjt as given:
Z
1 1
max Yt − Pjt Yjt dj
Yjt Pt 0
where Pt is an index (to be determined) that converts nominal expenditures into real expen-
ditures.
4.3. INTERMEDIATE GOODS 33

Optimal choice of Yjt solves:

"µZ ¶ ε−1
ε Z 1 #
1
∂ ε−1 1
Yjt ε dj − Pjt Yjt dj = 0
∂Yjt 0 Pt 0
µZ 1 ¶ ε−1
1
ε ε−1 ε − 1 −1 Pjt
⇔ Yjt ε dj Yjtε =
ε−1 0 ε Pt
| {z }
1/ε
Yt
µ ¶−ε
Pjt
Yjt = Yt
Pt
³ ´−ε
Pjt
From Yjt = Pt
Yt (demand for each input) use CES to obtain:
µ ¶−ε µZ 1 ¶ ε−1
ε
Pjt ε−1
Yjt = Yjt ε dj
Pt 0
and solving for Pt
³R ε−1 ´ 1−ε
1
1
Pjt 0 Yjt dj ε µZ 1 ¶ 1−ε
1

Pt = − 1ε
= Pjt1−ε dj
Yjt 0

Pt represents the minimum cost of achieving one unit of the Þnal-goods bundle Yt . For this
reason we interpret Pt as the aggregate price index.
In equilibrium proÞts in this sector will be equal to zero: this occurs because the produc-
tion function in the Þnal goods Þrm problem has constant returns to scale, therefore from
the Euler’s theorem there cannot be proÞts.

4.3 Intermediate goods

The intermediate goods sector is made by a continuum of monopolistically competitive Þrms
owned by consumers, indexed by j ∈ (0, 1).

4.3.1 The constraints

Each Þrm, as we saw above, faces a downward sloping demand for its product. It uses labor
to produce output according to the following technology:

Yjt = At Ljt

Each producer chooses her own sale Pjt taking as given the demand curve. He can reset
his price only when given the chance of doing so, which occurs with probability 1 −θ in every
period.
So, how many constraints do intermediate goods Þrms face?
34 CHAPTER 4. THE DYNAMIC NEW-KEYNESIAN MODEL

1. the production constraint: Yjt = At Ljt

³ ´−ε
P
2. the demand curve Yjt = Pjtt Yt

3. the fact that prices can be adjusted only with probability 1−θ. We follow Calvo (1983)
and assume that every period only a random fraction of Þrms is setting prices. Each
period, this fraction is independent from the previous period.

We can break this problem down into two sub-problems. As a cost minimizer and as a
price setter.

4.3.2 Producer as a cost minimizer

Consider the cost minimization problem Þrst, conditional on the output Yjt produced. This
problem involves minimizing Wt Ljt subject to producing Yjt = At Ljt (there is no sub-index
on Wt since all sectors where labor is employed must pay same wage in equilibrium). In real
terms this problem can be written as
Wt
min Ljt + Zt (Yjt − At Ljt ) [Zt ]
Ljt Pt
where Zt is multiplier associated with the constraint. The Þrst order condition implies:
Yjt 1 Wt Wt
= ≡ Xt (LD)
Ljt Zt Pt Pt
notice that this Þrst order condition suggests than we can write the real cost function as
Wt
COSTt = Ljt = Zt Yjt
Pt
For this reason, we can think of Zt as real marginal cost; we can likewise deÞne its inverse
Xt = 1/Zt as the markup. Given cost minimization, the Þrm takes Zt as given, when choosing
the output price, to which we turn now.

4.3.3 Producer as a price setter

4.3.3.1 Digression: the problem with ßexible prices (and the macro equilibrium
with ßexible prices)
In order to warm yourself up, consider the problem of a monopolistic producer who has the
chance to change her prices every period. The cost minimization problem is the same as
before. On the revenue side, deÞne rjt ≡ Pjt /Pt the relative price that the producer charges.
The maximization problem will be:

max rjt Yjt − Zt Yjt

rjt
4.3. INTERMEDIATE GOODS 35

−ε
where Yjt = rjt Yt . Optimal choice of rjt will imply
∂Yjt∗ ∂Yjt∗
Yjt∗ + rjt∗
∗
− Z t ∗
=0
∂rjt ∂rjt
µ ∗ ¶
∗
rjt ∂Yjt∗ Zt rjt∗
∂Yjt∗
Yjt 1 + ∗ ∗ − ∗ ∗ ∗ = 0
Yjt ∂rjt rjt Yjt ∂rjt
∗
∗
Pjt ε
rjt = = Zt
Pt ε−1
ε
that is, the relative price would be a constant markup X ≡ ε−1
over the real marginal cost.

Remark 9 This condition is crucial because with monopolistic competition but ßexible prices
we would derive a neutrality result similar to that of Sidrauski model. In the symmetric
equilibrium, Pjt = Pt , hence Zt = ε−1
ε
= X1 < 1 for all t. Combining labor supply (equation
LS) and labor demand (equation LD) and imposing market clearing Yt = Ct would give

wt = Ytρ Lη−1
t = At /X
labor supply labor demand

using Lt = Yt /At in the symmetric equilibrium we will have:

µ η ¶ ρ+η−1
1
At
Yt =
X
so that output in the model is a function only of technology. In static terms, output would
be suboptimally low.

4.3.3.2 The problem with sticky prices

To begin with, at any point in time if some intermediate good producers can change prices
and others cannot, the average price level will be a CES aggregate of all prices in the economy,
and will be
Pt1−ε = θPt−11−ε
+ (1 − θ) (Pt∗ )1−ε (*)
where Pt−1 is previous price level, and Pt∗ is avg price level chosen by those who have the
chance to change prices. It is at these guys that we look now.
Consider the intermediate goods producer who has a chance 1 − θ to reset prices at time
t. Call P ∗ the reset price. The demand curve is:
∗
¡ ¢−ε
Yjt+k = Pjt∗ /Pt+k Yt+k

for any period k ≥ 0 for which he will keep that price.

His maximization problem is:
X∞ µ µ ∗ ¶ ¶
k Pjt ∗
max (θβ) Et Λt,k − Zt+k Yjt+k (#)
∗
Pjt
k=0
Pt+k

Λt,k = (Ct /Ct+k )ρ

36 CHAPTER 4. THE DYNAMIC NEW-KEYNESIAN MODEL

where Zt is the real marginal cost. θ represents the probability that the price Pj∗ chosen
at t will still apply in later periods. This expression is the “expected discounted sum of all
proÞts that the price setter will make conditional on his choice of Pjt∗ and weighted by how
likely Pjt∗ is to stay in place in future periods”.
At time t, the price setter chooses P ∗ to maximize proÞt. Differentiate # with respect
to Pjt∗ /Pt+k ≡ rjt∗
(the relative price) to obtain

X
∞ · µ ∗ ∗ ¶¸
k ∗ ∗
∂Yjt+k ∂Yjt+k
(θβ) Et Λt,k Yjt+k + rjt ∗
− Zt+k ∗
=0
k=0
∂r jt ∂r jt
∗ ∗ ∗
take Yjt+k out, isolate elasticity of Yjt+k wrt rjt
" Ã !#
X∞
r ∗
jt ∂Y ∗
jt+k Z t+k r ∗
jt ∂Y ∗
jt+k
(θβ)k Et Λt,k Yjt+k
∗
1+ ∗ ∗
− ∗ ∗ ∗
=0
k=0
Y jt+k ∂r jt r jt Yjt+k ∂r jt

X∞ · µ ¶¸
k ∗ Zt+k
(θβ) Et Λt,k Yjt+k 1 − ε + ∗ ε =0
k=0
rjt
∗
rjt
multiply inside brackets by
1−ε
X∞ · µ ∗ ¶¸
k ∗
Pjt ε
(θβ) Et Λt,k Yjt+k − Zt+k =0
k=0
Pt+k ε − 1

In equilibrium, all the Þrms that reset the price choose the same price (and face the same
demand), hence
Pjt∗ = Pt∗
ε
These two expressions enter the equilibrium (using X = ε−1 = steady state markup ). One
is ∗ that we derived above, the other is:
X∞ · µ ∗ n ¶¸
k ∗ Pt Zt+k
(θβ) Et Λt,k Yt+k −X =0 (**)
k=0
Pt+k Pt+k
n
where Zt+k = Zt+k /Pt+k . Rearrange the expression above to obtain:
P∞ £ ¤
k ∗ −1 n
k=0 (θβ) Et Λt,k Yt+k Pt+k Zt+k
X∞
∗ n
Pt = X P∞ k £ ∗ −1
¤ = X φt,k Zt+k
k=0
k=0 (θβ) Et Λt,k Yt+k Pt+k

∗ P −1
(θβ)k Et [Λt,k Yt+k t+k ]
where φt,k = P∞ k ∗ P −1 . This expression says that the optimal price is a weighted
k=0 (θβ) Et [Λt,k Yt+k t+k ]
average of current and expected future nominal marginal costs. Weigths depend on expected
demand in the future, and how quickly Þrm discounts proÞts.
Therefore you can notice the following:

• Under purely ßexible prices, θ = 0 : the markup is a constant. Pt∗ = XZtn and optimal
prices are a multiple X of the marginal cost.
4.4. THE EQUILIBRIUM 37

• When θ > 0, the optimal price depends on future expected values of aggregate variables
n
(Pt+k , Yt+k ) as well as future nominal marginal costs Zt+k . Put differently, one can see
that all the ßuctuations in the markup are due to Þrms being unable to adjust prices.

4.4 The equilibrium

4.4.1 Closing the model
We need to combine everything, impose market clearing, and linearize around the steady
state.
Total output in economy is:
·Z 1 ¸ ε−1
ε ·Z 1 ¸ ε−1
ε
ε−1 ε−1
Yt = Yjt dj
ε
= (At Ljt ) ε dj
0 0

It is not possible to simplify this expression since input usages across Þrms differs. However
R1
the linear aggregator Yt0 = 0 Yjt dj is approximately equal to Yt within a local region of the
steady state. Hence for local analysis we can simply use

Yt = At Lt

Goods market clearing is simply Yt = Ct . Trivially, bond market clearing implies Bt = 0.

4.4.2 Monetary policy

We assume that the central bank policy sets the dynamics of money supply in a way to
achieve a target level of the interest rate. This way, the money demand equation becomes
redundant since it only serves to determine the behavior of endogenous money.
To better gain insight into this, consider money demand:
Mt Rt
= χcρt
Pt Rt − 1
In log-linear terms this becomes:
³ ´
bt = ψ ρC
R bt − m
bt (md)

where ψ is some positive coefficient. So far, we have speciÞed central bank policy as control
over a monetary aggregate, for instance, for constant money supply:
ct = 0
M

However, one can think of several other monetary rules: for instance, if the central banks
wants to peg the interest rate, it simply pegs nominal consumption growth so that:
ct = Pbt + ρC
M bt (ms)
38 CHAPTER 4. THE DYNAMIC NEW-KEYNESIAN MODEL

but this implies that we can rewrite money market equilibrium as:

bt = 0
R

and this is an interest rate rule. The point I want to make is: if money enters separably
the utility function, we can forget about money demand in the model, and we can close the
model by specifying any process for the policy instrument (M or R) we like to consider.

4.4.3 The equilibrium in levels

Let us look at the equation summarising the model:
µ ¶
1 Rt Pt
= βEt (1)
Ytρ ρ
Pt+1 Yt+1
Yt1−ρ−η = A−η
t /Zt (2)
³ X∞ ´1−ε
Pt1−ε 1−ε
= θPt−1 + (1 − θ) Et X φt,k Zt+k Pt+k (3)
k=0
õ ¶1+φπ !1−φr
φr Pt φ
Rt = Rt−1 Zt z εr,t (4)
Pt−1

1. is the aggregate demand equation: it combines goods market clearing with the Euler
equation for bonds

2. is the equilibrium in the labor market. Take labour demand (LD) and labor supply
(LS) and impose market clearing. Then equate (LD) and (LS) so as to eliminate of
the real wage w from that expression. Whenever you have L, remember to replace it
with Y /A.

3. is the equation that describes how the aggregate price level is a weigthed average of
(1) previous price level Pt−1 and (2) reset prices Pt∗ , which are in turn a function of
future expected marginal costs.

4. The last expression is the monetary policy rule. We assume that the central bank
chooses money supply so as to set the nominal interest rate to be a function of previous
interest rate, current inßation and current real marginal costs. This is a Taylor rule,
from John Taylor of Stanford University, who was the Þrst to notice in a 1993 seminal
paper that central banks set the interest rate as a function of inßation and output gap
(output gap=deviation of output from its natural rate). The last term εr,t represents
a monetary policy shock.
4.5. THE LOG-LINEAR EQUILIBRIUM 39

4.5 The log-linear equilibrium

4.5.1 Linearizing the Phillips curve

∗
Use Yt+k = (Pt∗ /Pt+k )−ε Yt+k and cancel out Pt∗ in numerator and denominator to obtain:

P∞ k ¡¡ ε−1
¢ ¢
(θβ) E t Λt,k P Yt+k Pt+k Zt+k
Pt∗ = X k=0
P∞ k ¡ t+k ε−1 ¢
k=0 (θβ) Et Λt,k Pt+k Yt+k

To gain insight into this expression, it is convenient to loglinearize it. Intuitively, we can
see that numerator and denominator only differ up to a multiple given by Pt+k Zt+k , which
in turn multiplies (θβ)k (1 − θβ). Hence we can expect that in log-linearising Y, P ε−1 and Λ
will cancel out and disappear. Rearranging and dividing by Pt :

Pt∗ X 1 X
∞ ∞
k £ ¤ £ ¤
ε−1
(θβ) Et Λt,k Yt+k Pt+k = X (θβ)k Et Λt,k Zt+k Yt+k Pt+k Pt+k
ε−1
Pt k=0 Pt k=0

LHS Þrst
³ ´X
∞
£ ¤ X∞
£ ¤ ³ ´
Pbt∗ − Pbt (θβ)k ΛY P ε−1 + b t,k + Ybt+k + (ε − 1) Pbt+k
(θβ)k ΛY P ε−1 Et Λ
k=0 k=0
RHS next
X · ¸ ³ ´
∞
k£ ¤ XX ∞
k ΛY P
ε
−Pt (θβ) ΛY P ε−1
+ (θβ) Et Λb t,k + Zbt+k + Ybt+k + εPbt+k =
k=0
P k=0 X
X∞
k£ ¤ X∞
k£ ¤ ³ ´
−Pt (θβ) ΛY P ε−1
+ (θβ) ΛY P ε−1 b b b b
Et Λt,k + Zt+k + Yt+k + εPt+k
k=0 k=0

hence:

P P∞ ³ ´
Pbt∗ ∞ k=0 (θβ)k
= k=0 (θβ) k
E t
bt+k + Zbt+k
P
P ³ ´
Pbt∗ = (1 − θβ) ∞k=0 (θβ) k
E t
b
Pt+k + Zbt+k (@)

Equation (@) simply states in log-linear terms that the optimal price has to be equal to a
weighted average of current and future marginal costs, weighted by the probability that this
price will hold in later periods too. So you assign weight 1 to today, weight θβ to tomorrow,
θ2 β 2 to the day after tomorrow, and so on. Notice the complete forwardlookingness of this
expression, and the fact that these weights need to be normalized (the sum of all of them is
1
1−θβ
, whose inverse premultiplies the summation - weights sum up to one -)
40 CHAPTER 4. THE DYNAMIC NEW-KEYNESIAN MODEL

But we know that:

Pbt − θPbt−1 = (1 − θ) Pbt∗

³³ ´ ³ ´ ´
b b b b b b 2 2
Pt − θPt−1 = (1 − θ) (1 − θβ) Et Pt + Zt + θβ Pt+1 + Zt+1 + θ β (...) + ...
³ ´ ³ ´
Pbt − θPbt−1 = (1 − θ) (1 − θβ) Pbt + Zbt + θβ Et Pbt+1 − θPbt
next period value of LHS
³ ´
Pbt − Pbt−1 = − (1 − θ) Pbt−1 + (1 − θ) (1 − θβ) Pbt + θβ Et Pbt+1 − θPbt + (1 − θ) (1 − θβ) Zbt
bt = (1 − θ) π
π bt+1 + (1 − θ) (1 − θβ) Zbt
bt + θβEt π

(1 − θ) (1 − βθ) b
bt = βEt π
π bt+1 + Zt
θ
This equation is nothing else but an “expectations augmented Phillips curve”, which
states that inßation rises when the real marginal costs rise. It takes a while to derive, but
again it is nothing else but an aggregate supply curve for the whole economy. Notice that
µ ¶
∂b
πt
∂ /∂β = − (1 − θ) < 0
∂Z bt
µ ¶
∂bπt
∂ /∂θ < 0
∂ Zbt

• the higher β, the higher the weight to future Zbt ’s, and the lower today’s elasticity to
current marginal cost

• the higher θ, the higher the chance that I will be stuck with my price for a long period,
and the higher the elasticity of Pbt∗ to Zbt . However, few prices will be changed in the
aggregate, therefore aggregate inßation will not be sensitive to the marginal cost.

4.5.2 The remaining equations

Equations (1), (2) and (4) are already linear in logs.
We assume that at and et follows AR (1) processes.

4.5.3 The complete log-linear model

From now on, we denote with lowercase variables deviations of variables from their respective
steady states. I now work in terms of the markup rather than the real marginal cost. When
we log-linearize the 4 expressions above, what we obtain the following system:
4.5. THE LOG-LINEAR EQUILIBRIUM 41

1
yt = Et yt+1 − (rt − Et π t+1 )
ρ
1 η
yt = zt + at
η+ρ−1 η+ρ−1
(1 − θ) (1 − βθ)
πt = βEt π t+1 + zt + ut
θ
rt = φr rt−1 + (1 − φr ) ((1 + φπ ) π t + φz zt ) + et

Remark 10 The linearized equations are in the Matlab Þle, where we use xt = −zt (the
real marginal cost Zt is the inverse of the markup Xt in levels, and xt = −zt in logs - see
equation LD). dnwk.m and dnwk_go.m simulate this model. It has 7 equations rather than
four, but you can forget about three of them. One equation is capital demand if you extend
this model to have capital as well (you can set the weight on K to be arbitrarily small in the
production function, so that equation does not count); the other says that Y = C; another
deÞnes λ as the marginal utility of consumption.

It is sometimes convenient to call ytn a new variable that deÞnes the equilibrium level
of output (the natural output) that would prevail under completely ßexible prices (θ = 0).
This way zt can in fact be eliminated. In fact, If Þrms were able to adjust prices optimally
each period, zt = 0 (since (1−θ)(1−βθ)
θ
⇒ ∞) and we would be able to deÞne the ßexible price
equilibrium values for real interest rate and output, which we call their “natural” rates:
ρη
rn rtn = (at − Et at+1 )
η+ρ−1
η
ytn = at
η+ρ−1
We can then derive an expression for xt as a function of the gap between ßexible price
and sticky price equilibrium, that is:
xt = (η + ρ − 1) (ytn − yt )
Hence x is positive whenever y is below y n , output is below its natural level. It is for this
reason that we sometimes refer to xt as the “output gap”, since x is proportional to the
shortfall of output from its natural level. ytn is an exogenous variable, since it depends only
on technology. With this convention, the dynamic new-keynesian model can be rewritten as:

yt = Et yt+1 − σ (rt − Et π t+1 ) (a)

π t = λ (yt − ytn ) + βEt π t+1 + ut (b)
rt = φr rt−1 + (1 − φr ) ((1 + φπ ) π t + φx (yt − ytn )) + et (c)
where λ = (η + ρ − 1) (1−θ)(1−βθ)
θ
, σ = 1/ρ. Some authors have also postulated cost push
shocks ut , that push inßation up. Some authors refer to the system made by (1), (2), (3) as
the “benchmark” dynamic-new keynesian model.
42 CHAPTER 4. THE DYNAMIC NEW-KEYNESIAN MODEL

1.5 0 1.5 0.5

TECNO SHOCK
Y R X π
-0.2 1 0
1
-0.4 0.5 -0.5
0.5
-0.6 0 -1

0 -0.8 -0.5 -1.5

0 10 20 0 10 20 0 10 20 0 10 20

0 0.4 2 1
INFLATION SHOCK

0.3 1.5
-0.5 0.5
0.2 1
-1 0
0.1 0.5

-1.5 0 0 -0.5
0 10 20 0 10 20 0 10 20 0 10 20
MONETARY SHOCK

0 0.8 4 0

0.6 3 -0.5
-1
0.4 2 -1
-2
0.2 1 -1.5

-3 0 0 -2
0 10 20 0 10 20 0 10 20 0 10 20
years years years years

Figure 4.1: Simulations from dnwk.m, ßexible (triangles) versus sticky price (circles) model

4.6 The dynamic effects of technology and monetary

shocks
The Matlab programs in my webpage will allow you to analyze the dynamics of this model
by means of impulse response functions. The plot compares the responses that obtain under
ßexible prices versus sticky prices. It was generated with dnwk.m1

Technology

1. Following a rise in technology, marginal costs fall. Since not all prices are free to fall
immediately, markups will rise. A fraction 1 − θ of “ßex price” Þrms will lower their
prices and hire more factors of production. A fraction θ of “Þxed price” Þrms will
be unable to lower their prices and to increase their sales and therefore will hire less
factors of production. Production rises less than with ßexible prices
1
ρa = 0.5 ; ρe = 0.0 ; ρu = 0.0 ; β = .99; η = 1.5 ; θ = .75 and .0001; X = 1.1 ; ρ = 1 ; φr = 0.8 ; φπ =
2 ; φx =0.0 ;
4.6. THE DYNAMIC EFFECTS OF TECHNOLOGY AND MONETARY SHOCKS 43

2. The theory of endogenous markup variations provides the crucial link that allows the
concerns of RBC models and conventional monetary models to be synthetised. In
addition, the markup directly measures the extent to which a condition for efficient
resource allocation fails to hold.

Monetary A monetary contraction leads to drop in output, rise in the nominal interest
rate, fall in inßation, and a rise in the output gap. These predictions, which are qualitatively
in line with the VAR evidence, are hard to obtain in the ßexible price model.

Inßation Inßation shocks are important in this setup because they generate a trade-off
between output gap versus inßation stabilization.