Monetary Policy in the New Keynesian Model

In this chapter, we consider monetary policy. Recall that in the neoclassical growth model, prices are fully flexible. In this case, changes in the level of money supply do not have any effect on real variables (i.e., the neutrality of money). Therefore, we need to introduce sticky prices into our model. However, before we can consider sticky prices, we need to first develop a model in which firms have price-setting power. In other words, firms need to have the power to set their prices before they can decide whether or not to change their prices. Consequently, we need to convert the market structure from perfect competition to monopolistic competition. In summary, we develop a New Keynesian model and find that increasing the money supply has an expansionary effect on the macroeconomy in the short run by increasing the demand for goods.