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On Determinacy and Learnability in a New Keynesian Model with Unemployment

  • Mewael F. Tesfaselassie
  • Eric Schaling

We analyze determinacy and stability under learning (E-stability) of rational expectations equilibria in the Blanchard and Galí (2006, 2008) New-Keynesian model of inflation and unemployment, where labor market frictions due to costs of hiring workers play an important role. We derive results for alternative specifications of monetary policy rules and alternative values of hiring costs as a percentage of GDP. Under low hiring costs – a typical part of the U.S. calibration – for policy rules based on current period inflation and unemployment our results are similar to those of Bullard and Mitra (2002). However, we find that the region of indeterminacy and E-instability in the policy space increases with the hiring costs. So, higher hiring costs – consistent with the European 'sclerotic' labor market institutions – seem to play an important part in explaining unemployment instability. Under lagged data based rules the area where monetary policy delivers both determinacy and E-stability shrinks. These rules perform worse according to these two dimensions when hiring costs go up. Finally, under expectations-based rules – unlike Bullard and Mitra (2002) – an additional explosive region is introduced. Here also the scope for determinacy and E-stability oriented monetary policy decreases. Interestingly – under the same rule and European 'sclerotic' labor market institutions – we find that responding too much to expected inflation and too little to expected unemployment may very well be self-defeating. When hiring costs are large, a central bank that follows such a policy rule could very easily end up in the worst-case scenario of both indeterminacy and E-instability

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Paper provided by Kiel Institute for the World Economy in its series Kiel Working Papers with number 1506.

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Length: 19 pages
Date of creation: Mar 2009
Date of revision:
Handle: RePEc:kie:kieliw:1506
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  1. Thomas Lubik & Michael Krause, 2003. "The (Ir)relevance of Real Wage Rigidity in the New Keynesian Model with Search Frictions," Economics Working Paper Archive 504, The Johns Hopkins University,Department of Economics.
  2. Blanchard, Olivier & Galí, Jordi, 2006. "A New Keynesian model with unemployment," CFS Working Paper Series 2007/08, Center for Financial Studies (CFS).
  3. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  4. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers 00/41, Department of Economics, University of York.
  5. Thomas Lubik & Michael Krause, 2004. "A Note on Instability and Indeterminacy in Search and Matching Models," Economics Working Paper Archive 518, The Johns Hopkins University,Department of Economics.
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