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Since John Maynard Keynes wrote the General Theory of Employment, Interest, and Money in 1936, Keynesian economics has been highly influential among academics and policymakers. Keynes has certainly had his detractors, though, with the most influential being Milton Friedman, Robert Lucas, and Edward C. Prescott. Monetarist thought, the desire for stronger theoretical foundations in macroeconomics, and real business cycle theory have at times been at odds with Keynesian economics. However, Keynesianism has remained a strong force, in part because its practitioners periodically adapt by absorbing the views of its detractors into the latest "synthesis."
John Hicks's IS-LM interpretation of Keynes (Hicks 1937) and the popularization of this approach, particularly in Samuelson's textbook (Samuelson 1997), gave birth to the "neoclassical synthesis." Later, the menu cost models developed in the 1980s were a response to a drive for a more serious theory of sticky prices (Mankiw 1985, Caplin and Spulber 1987). More recently, New Keynesian economists have attempted to absorb real business cycle analysis and other ideas from post-1972 macroeconomics into a "new neoclassical synthesis" (Goodfriend and King 1997).
The important New Keynesian ideas, as summarized, for example in Clarida, Galí, and Gertler (1999) andWoodford (2003), are the following:
1. The key friction that gives rise to short-run nonneutralities of money and the primary concern of monetary policy is sticky prices. Because some prices are not fully flexible, inflation or deflation induces relative price distortions and welfare losses.
2. Modern monetary economics is not part of the New Keynesian synthesis. New Keynesians typically regard the frictions that we encounter in deep (e.g., Lagos and Wright 2005) and not-so-deep (e.g., Lucas and Stokey 1987) monetary economics as being second-order importance. These frictions are absence-of-double-coincidence problems and information frictions that give rise to a fundamental role for monetary exchange, and typically lead to intertemporal distortions that can be corrected by monetary policy (for example, a ubiquitous result in monetary economics is Friedman's zero-nominal-interest-rate rule for correcting intertemporal monetary distortions). The Friedman rule is certainly not ubiquitous in New Keynesian economics.
3. The central bank is viewed as being able to set a short-term nominal interest rate, and the monetary policy problem is presented as the choice over alternative rules for how this nominal interest rate should be set in response to endogenous and exogenous variables.
4. There is a short-run Phillips curve tradeoff. A monetary policy that produces an increase in unanticipated inflation will tend to increase real aggregate output.
The goal of this paper is to construct a simple sticky-price New Keynesian model and then use it to understand and evaluate the ideas above. In this model there are some important departures from the typical New Keynesian models studied by Clarida, Galí, and Gertler; Woodford; and others. However, these departures will highlight where the central ideas and results in New Keynesian analysis are coming from.
For monetary economists, key aspects of New Keynesian economics can be puzzling. For example inWoodford (2003), the apparently preferred framework for analysis is a "cashless model" in which no outside money is held in equilibrium. Prices are denominated in terms of some object called money, and these prices are assumed to be sticky. The interest rate on a nominal bond can be determined in the cashless model, and the central bank is assumed capable of setting this nominal interest rate. Then, the monetary policy problem is formulated as the choice over rules for setting this nominal interest rate. This approach can be contrasted with the common practice in monetary economics, where we start with a framework in which money overcomes some friction, serves as a medium of exchange, and is held in equilibrium in spite of being dominated in rate of return by other assets. …