Chapter 12: The New Keynesian Model: The Backward-Looking Case
In Chapter 9, we analyzed optimal monetary policy in a forward-looking version of the New Keynesian model. That model has the advantage of being built on solid microeconomic foundations. Important features of the forward-looking model are that a. expectations about the future rate of inﬂation and output gap aﬀect their current levels. b. a change in monetary policy, brought about by an increase in the real rate of interest, has a contemporaneous eﬀect on both real output and the rate of inﬂation. c. there is no persistence in the rate of inﬂation or real output in the structural relations. The forward-looking model is, however, not immune to criticism. Critics point out that the forward-looking Phillips Curve in particular suﬀers from a number of undesirable features. In Chapter 8, we showed that the forwardlooking Phillips Curve is not consistent with the natural rate hypothesis. One might argue further that the forward-looking Phillips Curve gives rise to at least one implausible and counterintuitive prediction: a tightening in monetary policy that results in a negative output gap leads to a rise in expected inﬂation.1 Disinﬂation will also set in without delay if the central bank can directly aﬀect the current expectation of future inﬂation. As a rule, however, disinﬂation occurs gradually and involves substantial costs in terms of lost output. The purpose of this chapter is to show how the optimal policy rule, the reaction function underlying it, and the time series...
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