Inflation and monetary policy in medium-sized New Keynesian DSGE models

This chapter of the Research Handbook of Inflation (2025) reviews the evolution and current relevance of medium-scale New Keynesian Dynamic Stochastic General Equilibrium (DSGE) models, which serve as part of the core analytical framework in central banks and academic macroeconomics. The chapter assesses their capacity to analyse inflation dynamics, monetary transmission mechanisms, and policy interventions. Despite their exclusion of crisis-specific features, canonical models such as Smets and Wouters (2007) continue to explain inflation and output dynamics in the euro area and the US, owing in part to the differentiated effects of cost-push and demand shocks and the mitigating role of monetary policy. The chapter traces advancements in the European Central Bank’s New Area-Wide Model (NAWM), highlighting extensions that incorporate financial frictions, effective lower bounds, and energy price shocks. These enhancements have strengthened the model’s forecasting performance and interpretative power, especially during periods of unconventional monetary policy and energy-driven inflation. DSGE models are shown to be particularly effective for policy counterfactuals, enabling real-time assessments of policy decisions relative to model-based optimal policy. A robustness analysis under alternative scenarios demonstrates how policy rules can be evaluated through a welfare lens, informing the design of resilient monetary frameworks. Finally, the chapter identifies key modelling challenges exposed by recent inflation episodes and advocates for richer supply-side structures and nonlinear dynamics to improve the models’ capacity to capture complex macroeconomic developments. JEL Classification: E31, E32, E52, E58, C63