Question

In the basic New Keynesian model, suppose that there is an increase in the future marginal product of capital. 1. Suppose that the central bank does nothing. What will be the effect on current inflation and on output? 2. Suppose the economy initially has inflation equal to the central bank’s inflation target and an output gap of zero. When the shock occurs, what should the central bank do? Explain with the aid of diagrams.

Answer 1

ans....

In the Keynesian model, we thought of monetary policy as exogenous in the sense that the money supply, Mt which was set exogenously. In the real world, central banks adjust the money supply (and hence interest rates) endogenously in response to changing conditions. In response to a change in an exogenous variable, the central bank ought to adjust the money supply in such a way that an equilibrium of the sticky wage/price model is the same as the equilibrium of neoclassical model.

In the New Keynesian model, an optimal monetary policy calls on the central bank to endogenously adjust the money supply in such a way as to make the equilibrium coincide with the hypothetical efficient equilibrium. A changes in Mt and At+1 can generate co-movement. Another way of putting this is that the real business cycle model emphasizes supply shocks (changes in At) as the source of business cycles, whereas the New Keynesian model which emphasizes “demand” shocks (changes in the money supply and in expectations of the future, At+1, which are sometimes called Keynesian “animal spirits”) as the source of the business cycle.

The 'Taylor rule' indicates that the central bank should adjust the nominal interest rate in response to deviations of inflation from target and output from potential. According to this rule, the central bank raises the interest rates in response to inflation. On the other hand, it reduces interest rates to stimulate output.

The central bank uses open market operations to influence the nominal interest rate. In the short run, when prices are sticky and inflation expectations are unchanged, a change in the nominal interest rate which changes the real interest rate. The central bank is able to control the growth of money supply and that the demand for money is stable.