Chapter 12: The New Keynesian Model: The Backward-Looking Case
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...
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