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Reconciling the New Keynesian model with observed persistence

  • Leong , Kenneth

    (Bank of Finland Research)

Despite sound theoretical foundations a drawback of the New Keynesian model is its inability to generate adequate persistence in the variables it seeks to explain. A common solution is to modify the model to include lagged variables. However, this is unsatisfactory as many such modifications depart from the microeconomic underpinnings of the original model. This paper presents results from simulation exercises that support the fully forward-looking New Keynesian model. In particular, we show that the exchange rate channel of monetary policy, which has been largely overlooked in existing studies of persistence, is instrumental in generating inflation persistence. However, the combination of full forward-looking behaviour and an open economy is unable to generate sufficient persistence in the output gap. By including an autocorrelated noise term to the assumption of rational expectations, the model is capable of generating persistence that match those of US inflation, the output gap, the nominal interest rate, as well as the real exchange rate.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0219.pdf
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Paper provided by Bank of Finland in its series Research Discussion Papers with number 19/2002.

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Length: 33 pages
Date of creation: 03 Sep 2002
Date of revision:
Handle: RePEc:hhs:bofrdp:2002_019
Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/

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  1. Nicoletta Batini & Andrew G Haldane, 1999. "Forward-looking rules for monetary policy," Bank of England working papers 91, Bank of England.
  2. Marvin Goodfriend & Robert G. King, 1998. "The new neoclassical synthesis and the role of monetary policy," Working Paper 98-05, Federal Reserve Bank of Richmond.
  3. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  4. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
  5. Roberts, John M, 1995. "New Keynesian Economics and the Phillips Curve," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 975-84, November.
  6. N. Gregory Mankiw, 2000. "The Inexorable and Mysterious Tradeoff Between Inflation and Unemployment," NBER Working Papers 7884, National Bureau of Economic Research, Inc.
  7. Glenn D. Rudebusch, 2002. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Economic Journal, Royal Economic Society, vol. 112(479), pages 402-432, April.
  8. Jeremy Rudd & Karl Whelan, 2001. "New tests of the New-Keynesian Phillips curve," Finance and Economics Discussion Series 2001-30, Board of Governors of the Federal Reserve System (U.S.).
  9. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
  10. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters, in: Monetary Policy Rules, pages 127-156 National Bureau of Economic Research, Inc.
  11. Roberts John M., 2005. "How Well Does the New Keynesian Sticky-Price Model Fit the Data?," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-39, September.
  12. John M. Roberts, 1998. "Inflation expectations and the transmission of monetary policy," Finance and Economics Discussion Series 1998-43, Board of Governors of the Federal Reserve System (U.S.).
  13. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  14. Rotemberg, Julio J, 1982. "Monopolistic Price Adjustment and Aggregate Output," Review of Economic Studies, Wiley Blackwell, vol. 49(4), pages 517-31, October.
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