Lecture 4

Introduction to the New Keynesian DSGE Model

Maarten De Ridder

London School of Economics

Lent Term 2022

1 / 52
Business Cycles

3
2.5
2
1.5
1

1960q1 1980q1 2000q1 2020q1

Real Gross Domestic Product for the U.S. 1960-2020

Source: FRED

2 / 52
This term

Part I: Shocking theory of the business cycle (weeks 1-6)

I Introduction to business cycles X

I Real Business Cycle (RBC) Model X

I New Keynesian DSGE Models ⇐

Part II: Perspectives on business cycles and steady states (weeks 7-10)
I Persistent effects of recessions

I Aggregate shocks? Firm-heterogeneity and the business cycle

I Interesting steady states: firms, productivity, market power

3 / 52
Previous lecture

RBC models present microfounded theories of the business cycle. But:

I Unclear what ‘productivity shocks’ represent

I Underestimate volatility of employment, require high Frish elasticity

I No role for involuntary unemployment, little endog. propagation

I Price level does not matter: no analysis of inflation

I No role for, e.g., monetary policy

4 / 52
In the news

5 / 52
Inflation

GDP Consum. Invest. Employment

Inflation (t) 0.04 -0.18 0.01 0.26
Inflation (t+1 ) 0.19 -0.05 0.15 0.36
Inflation (t+2 ) 0.31 0.08 0.26 0.42
Inflation (t+3 ) 0.41 0.21 0.33 0.41
Correlation matrix for the U.S. 1960-2019 - Deviations from HP Trend, quarterly
Source: Fred

6 / 52
In the news

7 / 52
Some evidence

Effect of monetary policy on real economy:

I Endogeneity problem: central bank responds to forecasts

I Romer and Romer (2004): identify deviations from usual CB’s response
2
X
b
∆im = α + βim + [γj ∆ỹmj + λj (∆ỹmj − ∆ỹm−1j )
j=−1

+ ϕj π̃mj + θj (π̃mj − π̃m−1j )] + ρũm0 + εm

∆ỹmj , π̃mj , ũmj are forecast growth, inflation, unemployment, quart. j, meeting m

I Relationship between output and interest rate shocks:

1
X 36
X 24
X
∆yt = a0 + 1ak Dkt + bj εkt−j + ci ∆ykt−j
k=1 j=1 j=1

8 / 52
Some evidence

Impulse response to monetary policy shock of 1 percentage point (monthly)

Source: Romer and Romer (2004)

9 / 52
Christina Romer

Source: https://www.youtube.com/watch?v=psLIQekHAfo

10 / 52
Christina Romer AND ME

Source: https://www.youtube.com/watch?v=psLIQekHAfo

11 / 52
New Keynesian DSGE lectures

I Lecture 1: Introduction to nominal rigidity, set up NK-DSGE model

I Lecture 2: Solve model with sticky prices, determinacy, analysis

I Lecture 3: Unemployment in NK-DSGE, extensions, critiques

12 / 52
This lecture

I Introduction to nominal rigidities

I Solve the canonical New Keynesian model under flexible prices

I Derive optimal price setting with nominal rigidity

13 / 52
Reference

Gali (2008) Monetary Policy, Inflation and the Business Cycle, Ch 1 and 3

14 / 52
This lecture

I Introduction to nominal rigidities

I Set up the canonical New Keynesian model under flexible prices

I Derive optimal price setting with nominal rigidity

14 / 52
Nominal rigidities

New Keynesian DSGE add nominal rigidities to the RBC model

I Price rigidity: price-adjustments are less frequent than expected

I Wage (..): wage-adjustments are very infrequent, esp. downwards

Key conceptual difference: business cycle is inefficient

I Output and employment are lower (or higher) than optimal

I Model can allow for involuntary unemployment

15 / 52
Are prices sticky?

Price stickiness is straightforward to observe

I Supply and demand vary constantly ⇒ consumer prices do not

I What about Uber?

Significant evidence in the literature. E.g.:

I Median price duration is 8 to 11 months in U.S. CPI micro data
(Nakamura and Steinsson 2006)
I Some evidence that prices are even more sticky in the Euro Area
(Dhyne et al. 2006)
I Although there is significant heterogeneity across products
(Taylor 1999, Dhyne et al. 2006, Cavallo 2018 - ‘Billion Prices Project’)

16 / 52
Are prices sticky?

Prices also respond slower than output after shocks:

Impulse response to monetary policy shock of 1 percentage point (monthly)

Source: Romer and Romer (2004)

17 / 52
Are prices sticky?

Prices also respond slower than output after shocks:

Impulse response to monetary policy shock of 1 percentage point (monthly)

Source: Romer and Romer (2004)

18 / 52
Are prices sticky?

Prices also respond slower than output after shocks:

Impulse response to monetary policy shock of 1 percentage point (quarterly)

Source: Christiano Eichenbaum Evans (1999)

19 / 52
Why are prices sticky?

Many theories... (see Blinder 1994)

I Menu costs: price changes are too costly

I Prices fixed by contracts

I Implicit contracts: price changes ‘unfair’, risk of losing customers

I Cost-based pricing rules: costs may be sticky → don’t change price

I Sticky information: don’t know you should change price

(Mankiw and Reis 2002)

20 / 52
Sticky wages?

Distribution of nominal wage changes in Germany

Source: Ehrlich and Montes (2020)

21 / 52
Sticky wages?

Relation between ∆ unemployment and ∆ wage for vacancies (U.S.)

Source: Hazell (2020)

22 / 52
Sticky wages?

Rigidity in wages is heterogeneous across countries (using spike at 0)

Source: Dickens et al. (2007)

23 / 52
Why are wages sticky?

Reference: Bewley (1999) ‘Why Wages Don’t Fall During Recessions’

I Interviews with 300 managers during 1990s recession

Rigidity is mainly driven by:

I Morale
I Pay cuts hit everyone, layoffs only the laid off
I Increases staff turnover, reduces productivity

I Distributional effect: best staff leaves (layoff: least productive staff)

24 / 52
This lecture

I Introduction to nominal rigidities

I Set up the canonical New Keynesian model, flexible prices

I Derive optimal price setting with nominal rigidity

24 / 52
Overview

Households:
I Consume a basket of goods and supply labor to firms

I Save in the form of a risk-free government bond

I Own firms and receive dividends if they make profits

Firms:
I Produce differentiated goods

I Choose the price at which they sell their variety; staggered (Calvo)

Central Bank:
I Set the nominal interest rate on government bonds

25 / 52
Representative household: problem

∞
X
max E0 β t U(Ct , Lt ),
Ct ,Nt ,Bt ,Ci,t
t=0

subject to
Z 1
Pi,t Ci,t di + Qt Bt ≤ Bt−1 + Wt Lt + Profitst , and no-ponzi
0

I Bt : one-period, riskless, bonds maturing in t + 1

I Qt : price of bond paying one unit of money at maturity
I Consumption is an aggregate of individual goods i:

26 / 52
Representative household: changes

1. Prices now feature in the budget constraint

I Bonds carry risk-free nominal interest rate Qt−1 − 1

2. Consumption goods are no longer perfect substitutes

I There is a continuum of varieties of measure 1
I Households derive utility from consuming a basket of goods

Z 1  −1
1−1/
Ct = Ci,t di
0

I Constant Elasticity of Substitution (CES) aggregator, elasticity  > 1

27 / 52
Representative household: consumption bundle
Bundle of varieties Ct is chosen to minimize expenditures.
Z 1 Z   !
1 −1
1−1/
L = Pi,t Ci,t di − λ Ci,t di − Ct
0 0

  Z 1  −1 −1
∂L  −1/ 1−1/
= Pi,t − λ [1 − 1/] C Ci,t di =0
∂Ci,t  − 1 i,t 0
−
⇒ Ci,t = λ pi,t Ct

Hence relative demand for any two goods i and j:

−
Ci,t /Cj,t = (Pi,t /Pj,t )

As a function of total expenditure:

− − 1
R
Z 1 Z 1 
Pj,t P C di
Pi,t 0 i,t i,t
Pi,t Ci,t di = Pi,t Cj,t di ⇒ Cjt = R 1 1−
0 0 Pj,t P di
0 i,t

28 / 52
Representative household: consumption bundle and prices
Definition: price index Pt is expenditure required to purchase 1 basket
R1
Pi,t Ci,t di
Pt = 0
Ct
To find the index, insert the demand for individual goods i :
R1
Pi,t Ci,t di
Pt = hR 0 i 
1 1−1/ −1
0
C i,t di
 − R 1 
R1 Pi,t 0 Pi,t Ci,t di
0
Pi,t R 1 1− di
0 Pi,t di
= "  1−1/ # −1 
R 1 Pi,t − R 1
0 Pi,t Ci,t di
0
R 1 1− di
0 Pi,t di

1
Z 1  1−
1−
= Pi,t di
0

29 / 52
Representative household: optimality

Optimal consumption and bond holdings (Euler):

" #
UC0 ,t+1 Pt
Qt = βEt
UC0 ,t Pt+1

Static labor vs consumption optimization:

0
UL,t Wt
− 0 =
UC ,t Pt

Optimal expenditure allocation

 −
Pi,t
Ci,t = Ct
Pt

30 / 52
Representative household: optimality

Remainder of the lecture:

Ct1−σ − 1 L1+ϕ
U(Ct , Lt ) = − t
1−σ 1+ϕ

Euler equation:
" #
UC0 ,t+1 Pt
 σ 
Ct Pt
Qt = βEt ⇒ Qt = βEt
UC0 ,t Pt+1 Ct+1 Pt+1

Static labor vs consumption optimization:

0
UL,t Wt Wt
− 0 = ⇒ Ctσ Lϕ
t =
UC ,t Pt Pt

31 / 52
Representative household: log-linearized

Notation:
xt ≡ log Xt

Euler equation:
 
1
ct = Et (ct+1 ) − it − Et [πt+1 ] − ρ 

σ
 |{z}
| {z } |{z}
−logQt logPt+1 /Pt −logβ

Static labor vs consumption:

wt − pt = σct + ϕlt
(note: add log-steady state values)

32 / 52
Derivation?

32 / 52
Firms

I There is no longer a representative firm: firms produce a variety

I Firm index i, continuum of measure 1, monopolist in production of i

I All firms have the same production function, same productivity:

Yi,t = At L1−α
i,t

I As monopolist in production of i, they have pricing power

I But sticky prices: firms can choose price only with probability 1 − θ

33 / 52
Firms: flexible price
Say prices were flexible and firms could set them every t:
I Firm maximizes present value of dividends for owners (households)

I Households discount utility at rate β but income at rate Qt,t+k

I Qt,t+k : inv. gross nominal interest between today (t) and t + k

−1
I Intuition: if household saves 1 today, expects 1 · Qt,t+k at t + k
h U0 i h U0 i
Pt
I From Euler: Qt,t+1 = β C ,t+1
UC0 ,t Pt+1
⇒ Qt,t+k = β k C ,t+k
UC0 ,t
Pt
Pt+k

I Qt,t+k is also known as the ‘stochastic discount factor’

I Hence, firms maximize:

∞
X
Et Qt,t+k (Pi,t+k Yi,t+k − Wt+k Lit+k )
k=0

34 / 52
Firms: flexible price

Optimization problem:
∞
X
max Et Qt,t+k (Pi,t+k Yi,t+k − Wt+k Lt+k )
Pi,t+k
k=0
−
s.t. Yit = (Pit /Pt ) Ct and Yit = At L1−α
it

Inserting the constraints:

 1 
∞  − " − # 1−α
X Pi,t+k Pi,t+k Ct+k
max Et Qt,t+k Pi,t+k Ct+k − Wt+k 
Pi,t+k Pt+k Pt+k At+k
k=0

35 / 52
Firms: flexible price
 1 
∞ − " − #
 1−α
X Pi,t+k Pi,t+k Ct+k
max Et Qt,t+k Pi,t+k Ct+k − Wt+k 
Pi,t+k Pt+k Pt+k At+k
k=0

1. Take first order condition with respect to Pi,t+k

 " # 1 
 − − 1−α
Pi,t+k 1 −1 Pi,t+k Ct+k
Et [1 − ] Ct+k + Wt+k Pi,t+k =0
Pt+k 1−α Pt+k At+k

2. Symmetric equilibrium: all firms have same FOC s.t. Pi,t+k = Pt+k
1
α
  
FLEX  1 1 1−α
1−α
Pt+k = Wt+k Ct+k
−1 1−α At+k

Standard result for CES competition with flexible prices :

I Price is constant markup ε

ε−1
over marginal cost
I Note: marginal cost is Wt /At if α = 0

36 / 52
Aggregate variables

Wages:
I First order condition for pricing:
   1
 1 1 1−α α
Pit = Wt Ct1−α
−1 1−α At

I Divide by price index, impose symmetry such that Pit = Pt

   1 !
 Wt 1 1 1−α 1−α α
1= Ct
 − 1 Pt 1 − α At

 
1
Wt −1  1−α
α
− 1−α
= At Ct (1 − α)

Pt  | {z }
MPLt

37 / 52
Aggregate variables

Wage is marked down because of market power in product market

I ‘Aggregate Demand externality’

I Lower wage reduces labor supply:

  1/ϕ
Wt
Lt = Ct−σ
Pt
  1/ϕ
 − 1 1−α
1
− α
= Ct−σ At Ct 1−α (1 − α)


38 / 52
Aggregate variables
GDP:

I From the goods market equilibrium Ct = Yt , Cit = Yit :


Z 1  −1
1−1/
Yt = Yi,t di
0

I Production function Yit = At L1−α

it and using symmetry:

Z 1
1−1/
 −1
Yt = At L1−α
t di = At L1−α
t
0

I Insert labor supply, isolate output:

ϕ+1
  1−α
ζ −1 ζ 1−α
Yt = At (1 − α) ζ


where ζ = σ(1 − α) + α + ϕ

39 / 52
Flexible price symmetric equilibrium

Definition: sequence for the combination of quantities and prices

{Lt , Wt /Pt , Yt } such that:
I Households first order condition for optimal labor supply

I Firm’s first order condition for optimal prices (subject to demand)

I Technology constraint: production function

40 / 52
Flexible price symmetric equilibrium

Definition: sequence for the combination of quantities and prices

{Lt , Wt /Pt , Yt , Ct } such that:
I Households first order condition for optimal labor supply

I Firm’s first order condition for optimal prices (subject to demand)

I Technology constraint: production function

I Resource constraint: Ct = Yt

40 / 52
Flexible price symmetric equilibrium

Definition: sequence for the combination of quantities and prices

{Lt , Wt /Pt , Yt , Ct , Et (Pt /Pt+1 )Qt−1 } such that:
I Households first order condition for optimal labor supply

I Firm’s first order condition for optimal prices (subject to demand)

I Technology constraint: production function

I Resource constraint: Ct = Yt

I Ex-ante real interest rate from Euler equation

Note: we don’t have determinacy for nominal interest rate, inflation

40 / 52
Efficiency

Compared to the social efficient level, there is too little production

I Firms raise prices to maximize profits

I Higher prices ⇒ lower output, lower labor demand

I Lower wages reduce labor supply if labor is supplied elastically

Social planner would set markup to 1:

ϕ+1 1−α
Yt∗ = At ζ (1 − α) ζ

 1−α
YtFlex

−1 ζ
= <1
Yt∗ 

41 / 52
This lecture

I Introduction to nominal rigidities

I Set up the canonical New Keynesian model under flexible prices

I Derive optimal price setting with nominal rigidity

41 / 52
Calvo pricing

The Calvo Fairy

I Firms change price with probability (1 − θ)

I Expected price duration: (1 − θ)−1

42 / 52
Firms: sticky prices

I Firms will no longer be in a symmetric equilibrium

I At time t, set price Pit∗ to maximize present value of dividends:

∞
X
Pit∗ = arg max θk Et Qt,t+k (Pi,t Yi,t+k − Wt+k Lit+k )
Pi,t+k
k=0

s.t. Yit+k = (Pit /Pt+k )− Ct+k and Yi,t+k = At+k L1−α
it+k

I Define Ψt+k Yt+k|t as costs at t+k for firm that set prices at t
∞ −
Pt∗
X 
θk Et Qt,t+k Pt∗ Yt+k|t − Ψt+k Yt+k|t



max s.t. Yt+k|t = Ct+k
Pt+k
k=0

43 / 52
Firms: sticky prices
First order condition:
∞
!
X ∂Yt+k|t ∂Ψt+k Yt+k|t ∂Yt+k|t
k
θ Et Qt,t+k Yt+k|t + Pt∗ − =0
∂Pt∗ ∂Yt+k|t ∂Pt∗
k=0

where: −
Pt∗
   
∂Yt+k|t  Yt+k|t
=− Ct+k = −
∂Pt∗ Pt∗ Pt+k Pt∗


∂Ψt+k Yt+k|t
= ψt+k|t ⇒ nominal marginal cost
∂Yt+k|t

such that:
∞   
X Yt+k|t
θk Et Qt,t+k Yt+k|t (1 − ε) − ψt+k|t (−) =0
Pt∗
k=0
 
∞  

X  
θk Et Qt,t+k Yt+k|t Pt∗ − ψt+k|t =0
 
 −1 
k=0 | {z }
flex price m.u. x mar. costs

44 / 52
Firms: sticky prices log-linearized

Rewrite the first order condition in terms with well-defined steady state:
∞    
X 
θk Et Qt,t+k Yt+k|t Pt∗ − ψt+k|t = 0
−1
k=0
 
∞
 Pt∗
 
X 
θk Et Qt,t+k Yt+k|t 

 Pt−1 − −1
MCt+k|t Πt−1,t+k 
| {z } | {z } 
=0
k=0
ψt+k|t /Pt+k Pt+k /Pt−1

To log-linearize around the steady state, use:

I Zero inflation: Pt∗ /Pt−1 = 1 and Πt−1,t+k = 1

I Symmetry: Yt,t+k = Y , MCt+k|t = MC , P ∗ = Pt+k

I No inflation, growth: same discounting for income and utility Qt,t+k = β k

45 / 52
Firms: sticky prices log-linearized
Left-hand side of the equation:
∞
Pt∗
X  
Xt = θk Et Qt,t+k Yt+k|t
k=0
Pt−1

Step 1: steady state using Pt∗ /Pt−1 = 1 and Πt−1,t+k = 1, Qt,t+k = β k , symmetry:
Y
X =
1 − βθ
Step 2: log-linearize the left hand side equation:
I Write the function in exponential terms in deviations from the steady state:
∞
∗
 
θk Et Qt,t+k Y e qbt,t+k +byt+k|t +pt −pt−1
X
Xt =
k=0

I First-order Taylor approximation:(update: also take derivative w.r.t. Q)

 
∞ ∂Xt ∂Xt ∂Xt ∗
X      
Xt ≈ X + Et  qbt,t+k + ybt,t+k  + pt − pt−1
k=0 ∂q
bt,t+k Xt =X ∂b
yt+k|t Xt =X ∂pt∗ − pt−1 Xt =X

∞ Y
k ∗
X  
= X +Y (θβ) Et (b
qt,t+k + ybt+k|t ) + pt − pt−1
k=0 1 − βθ

46 / 52
Firms: sticky prices log-linearized
Right-hand side of the equation:
∞  
X 
Xt = θk Et Qt,t+k Yt+k|t MCt+k|t Πt−1,t+k
k=0
−1

Step 1: steady state using Pt∗ /Pt−1 = 1 and Πt−1,t+k = 1, Qt,t+k = β k , symmetry:
Y 
X = MC
1 − βθ  − 1
Step 2: log-linearize the left hand side equation:
I Write the function in exponential terms in deviations from the steady state:
∞  
X  
Xt = θk Et Qt,t+k Y (MC ) e qbt+k|t +byt+k|t +mc
c t+k|t +πt−1,t+k

k=0
−1

I First-order Taylor approximation:

 
∞
X ∂Xt   ∂Xt   ∂Xt  
Xt ≈ X + Et  qbt+k|t + ybt+k|t + mc
c t+k|t 
k=0 ∂q
bt+k|t Xt =X ∂b
yt+k|t Xt =X ∂ mc
c t+k|t ..

∂Xt  
+ πt−1,t+k
∂π
b t−1,t+k .


! ∞
k
X  
= X + MC Y (θβ) Et qbt+k|t + ybt+k|t + mc
c t+k|t + πt−1,t+k
−1 k=0

47 / 52
Firms: sticky prices log-linearized
Left-hand side log-linearized:
∞
X Y
X +Y (θβ)k Et (b
qt,t+k + ybt+k|t ) + (pt∗ − pt−1 )
1 − βθ
k=0

Right-hand side log-linearized:

  ∞
 X
(θβ)k Et qbt,t+k + ybt+k|t + mc


X + MC Y c t+k|t + πt−1,t+k
−1
| {z } k=0

=1 given P=MC ·P −1

Equate and solve for pt∗ − pt−1 to get:

∞
X
pt∗ − pt−1 (θβ)k Et mc


= (1 − βθ) c t+k|t + πt−1,t+k
k=0
∞
X
(θβ)k Et (mc


= (1 − βθ) c t+k|t + pt+k − pt−1
k=0

48 / 52
Price index

Advantage of log-linearization: straightforward expression for inflation

I How does price index develop?
1
Z 1  1−
1−
Pt = Pi,t di
0
 1
 1−
 Z 1 Z 1 
1− ∗ 1− 
 
= θ
 Pi,t−1 di +(1 − θ) (Pt ) di 
 | 0 {z } | 0 {z }
1− (Pt∗ )1−
Pt−1
 1
θPt−1 + (1 − θ)(Pt∗ )1− 1−
 1−
=

I Note: continuum of firms, law of large numbers applies

49 / 52
Price index

I Index:
 1
+ (1 − θ)(Pt∗ )1− 1−
 1−
Pt = θPt−1

I Define: gross inflation rate is

1−
Pt∗

Pt
Πt ≡ ⇒ Π1−
t = θ + (1 − θ)
Pt−1 Pt−1

I Log-linearized:

πt = (1 − θ)(pt∗ − pt−1 )

50 / 52
Next week

I Dynamic IS Equation

1
ybt = − (it − Et (πt+1 ) − ρ) + Et (yd
t+1 )
σ

I New Keynesian Philips Curve

πt = βEt (πt+1 ) + κybt

I Monetary policy rule:

it = ρ + φπ πt + φy ybt + vt

51 / 52
What have we done?

1. Empirical evidence: nominal rigidity, real effect of monetary policy X

2. Setup of the New Keynesian Model

I Constant Elasticity of Substitution Aggregator (CES) X
I Derive first order conditions for sticky-price firm problem X
I Linearize household and firm first order conditions X

3. Derive the equilibrium under flexible prices X

52 / 52