How does heterogeneity affect the effectiveness of monetary policy and the properties of economic... more How does heterogeneity affect the effectiveness of monetary policy and the properties of economic fluctuations? Using the distinction between constrained and unconstrained households at each point in time, we identify three channels at work in Heterogeneous Agent New Keynesian (HANK) models: (i) changes in the average consumption gap between constrained and unconstrained households, (ii) variations in consumption dispersion within unconstrained households, and (iii) changes in the share of constrained households . We analyze the quantitative importance of each of those factors for output fluctuations in a baseline HANK model. We show that a simple Two-Agent New Keynesian (TANK) model, with a constant share of constrained households and no heterogeneity within either type, approximates reasonably well the implications of a HANK model regarding the effects of aggregate shocks on aggregate output..
T HAS BEEN a great resurgence of interest in the issue of how to conduct monetary policy. One sym... more T HAS BEEN a great resurgence of interest in the issue of how to conduct monetary policy. One symptom of this phenomenon is the enormous volume of recent working papers and conferences on the topic. Another is that over the past several years many leading macroeconomists have either proposed specific policy rules or have at least staked out a position on what the general course of monetary policy should be. John Taylor’s recommendation of a simple interest rate rule (Taylor 1993a) is a well-known example. So too is the recent widespread endorsement of inflation targeting (e.g., Ben Bernanke and Frederic Mishkin 1997). Two main factors underlie this rebirth of interest. First, after a long period of near exclusive focus on the role of nonmonetary factors in the business cycle, a stream of empirical work beginning in the late 1980s has made the case that monetary policy significantly influences the short-term course of the real economy.3 The precise amount remains open to debate. On t...
We study how changes in the value of the steady-state real interest rate affect the optimal infla... more We study how changes in the value of the steady-state real interest rate affect the optimal inflation target, both in the U.S. and the euro area, using an estimated New Keynesian DSGE model that incorporates the zero (or effective) lower bound on the nominal interest rate. We find that this relation is downward sloping, but its slope is not necessarily one-forone: increases in the optimal inflation rate are generally lower than declines in the steadystate real interest rate. Our approach allows us not only to assess the uncertainty surrounding the optimal inflation target, but also to determine the latter while taking into account the parameter uncertainty facing the policy maker, including uncertainty with regard to the determinants of the steady-state real interest rate. We find that in the currently empirically relevant region for the US as well as the euro area, the slope of the curve is close to -0.9. That finding is robust to allowing for parameter uncertainty.
I develop a version of the New Keynesian model with insideroutsider labor markets and hysteresis ... more I develop a version of the New Keynesian model with insideroutsider labor markets and hysteresis that can account for the high persistence of European unemployment. I study the implications of that environment for the design of monetary policy. The optimal policy calls for strong emphasis on unemployment stabilization which a standard interest rate rule fails to deliver, with the gap between the two increasing in the degree of hysteresis. A simple interest rule that includes the unemployment rate is shown to approximate well the optimal policy.
We study how changes in the steady-state real interest rate affect the optimal inflation target i... more We study how changes in the steady-state real interest rate affect the optimal inflation target in a New Keynesian DSGE model with trend inflation and a lower bound on the nominal interest rate. In this setup, a lower steady-state real interest rate increases the probability of hitting the lower bound. That effect can be counteracted by an increase in the inflation target, but the resulting higher steadystate inflation has a welfare cost in and of itself. We use an estimated DSGE model to quantify that tradeoff and determine the implied optimal inflation target, conditional on the monetary policy rule in place before the financial crisis. The relation between the steady-state real interest rate and the optimal inflation target is downward sloping. While the increase in the optimal inflation rate is in general smaller than the decline in the steady-state real interest rate, in the currently empirically relevant region the slope of the relation is found to be close to-1. That slope is robust to allowing for parameter uncertainty. Under "make-up" strategies such as price level targeting, the required increase in the optimal inflation target under a lower steady-state real interest rate is, however, much smaller.
Unconditional reduced form estimates of a conventional wage Phillips curve for the U.S. economy p... more Unconditional reduced form estimates of a conventional wage Phillips curve for the U.S. economy point to a decline in its slope coefficient in recent years, as well as a shrinking role of lagged price inflation in the determination of wage inflation. We provide estimates of a conditional wage Phillips curve, based on a structural decomposition of wage, price and unemployment data generated by a VAR with time varying coefficients, identified by a combination of long-run and sign restrictions. Our estimates show that the key qualitative findings from the unconditional reduced form regressions also emerge in the conditional evidence, suggesting that they are not entirely driven by endogeneity problems or possible changes over time in the importance of wage markup shocks. The conditional evidence, however, suggests that actual changes in the slope of the wage Phillips curve may not have been as large as implied by the unconditional estimates. Resumen Jordi Galí CREI, UPF and Barcelona GSE Luca Gambetti UAB and Barcelona GSE
We develop a utility based model of fluctuations, with nominal rigidities, and unemployment. In d... more We develop a utility based model of fluctuations, with nominal rigidities, and unemployment. In doing so, we combine two strands of research: the New Keynesian model with its focus on nominal rigidities, and the Diamond-Mortensen-Pissarides model, with its focus on labor market frictions and unemployment. In developing this model, we proceed in two steps. We first leave nominal rigidities aside. We show that, under a standard utility specification, productivity shocks have no effect on unemployment in the constrained efficient allocation. We then focus on the implications of alternative real wage setting mechanisms for fluctuations in unemployment. We then introduce nominal rigidities in the form of staggered price setting by firms. We derive the relation between inflation and unemployment and discuss how it is influenced by the presence of real wage rigidities. We show the nature of the tradeoff between inflation and unemployment stabilization, and we draw the implications for optimal monetary policy. JEL-code : E32, E50.
Recent evidence on the e ects of an exogenous increase in government spending on consumption cann... more Recent evidence on the e ects of an exogenous increase in government spending on consumption cannot be easily reconciled with existing optimizing business cycle models. We develop a simple dynamic model where the interaction of rule-of-thumb consumers and staggered price setting in goods markets can potentially account for that evidence.
Hysteresis and the European Unemployment Problem After twenty years of negligible unemployment, m... more Hysteresis and the European Unemployment Problem After twenty years of negligible unemployment, most of Western Europe has since the early 1970s suffered a protracted period of high and rising unemployment. In the United Kingdom unemployment peaked at 3.3 percent over the period 1945-1970, but has risen almost continuously since 1970, and now stands at over 12 percent. For the Common Market nations as a whole, the unemployment rate more than doubled between 1970 and 1980 and has doubled again since then. Few forecasts call for a significant decline in unemployment over the next several years, and none call for its return to levels close to those that prevailed in the 1950s and 1960s.
Journal of the European Economic Association, 2011
The standard New Keynesian model with staggered wage setting is shown to imply a simple dynamic r... more The standard New Keynesian model with staggered wage setting is shown to imply a simple dynamic relation between wage in ‡ation and unemployment. Under some assumptions, that relation takes a form similar to that found in empirical wage equations-starting from Phillips' (1958) original work-and may thus be viewed as providing some theoretical foundations to the latter. The structural wage equation derived here is shown to account reasonably well for the comovement of wage in ‡ation and the unemployment rate in the U.S. economy, even under the strong assumption of a constant natural rate of unemployment.
Most central banks perceive a trade‐off between stabilizing inflation and stabilizing the gap bet... more Most central banks perceive a trade‐off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade‐off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare‐relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence, is due to a special feature of the model: the absence of nontrivial real imperfections. We focus on one such real imperfection, namely, real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade‐off between stabilizing inflation and stabilizing the welfare‐relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interp...
We develop and estimate a structural model of inflation that allows for a fraction of firms that ... more We develop and estimate a structural model of inflation that allows for a fraction of firms that use a backward looking rule to set prices. The model nests the purely forward looking New Keynesian Phillips curve as a particular case. We use measures of arginal cost as the relevant determinant of inflation, as the theory suggests, instead of an ad-hoc output gap. Real marginal costs are a significant and quantitatively important determinant of inflation. Backward looking price setting, while statistically significant, is not quantitatively important. Thus, we conclude that the New Keynesian Phillips curve provides a good first approximation to the dynamics of inflation.
We study the international monetary policy design problem within an optimizing two-country sticky... more We study the international monetary policy design problem within an optimizing two-country sticky price model, where each country faces a short run tradeoff between output and inflation. The model is sufficiently tractable to solve analytically. We find that in the Nash equilibrium, the policy problem for each central bank is isomorphic to the one it would face if it were a closed economy. Gains from cooperation arise, however, that stem from the impact of foreign economic activity on the domestic marginal cost of production. While under Nash central banks need only adjust the interest rate in response to domestic inflation, under cooperation they should respond to foreign inflation as well. In either scenario, flexible exchange rates are desirable.
In this paper we provide evidence on the fit of the New Phillips Curve (NPC) for Spain over the m... more In this paper we provide evidence on the fit of the New Phillips Curve (NPC) for Spain over the most recent disinflationary period (1980-1998). Some of the findings can be summarized as follows: (a) the NPC fits the data well; (b) yet, the backward looking component of inflation is important; (c) the degree of price stickiness implied by the estimates
How does heterogeneity affect the effectiveness of monetary policy and the properties of economic... more How does heterogeneity affect the effectiveness of monetary policy and the properties of economic fluctuations? Using the distinction between constrained and unconstrained households at each point in time, we identify three channels at work in Heterogeneous Agent New Keynesian (HANK) models: (i) changes in the average consumption gap between constrained and unconstrained households, (ii) variations in consumption dispersion within unconstrained households, and (iii) changes in the share of constrained households . We analyze the quantitative importance of each of those factors for output fluctuations in a baseline HANK model. We show that a simple Two-Agent New Keynesian (TANK) model, with a constant share of constrained households and no heterogeneity within either type, approximates reasonably well the implications of a HANK model regarding the effects of aggregate shocks on aggregate output..
T HAS BEEN a great resurgence of interest in the issue of how to conduct monetary policy. One sym... more T HAS BEEN a great resurgence of interest in the issue of how to conduct monetary policy. One symptom of this phenomenon is the enormous volume of recent working papers and conferences on the topic. Another is that over the past several years many leading macroeconomists have either proposed specific policy rules or have at least staked out a position on what the general course of monetary policy should be. John Taylor’s recommendation of a simple interest rate rule (Taylor 1993a) is a well-known example. So too is the recent widespread endorsement of inflation targeting (e.g., Ben Bernanke and Frederic Mishkin 1997). Two main factors underlie this rebirth of interest. First, after a long period of near exclusive focus on the role of nonmonetary factors in the business cycle, a stream of empirical work beginning in the late 1980s has made the case that monetary policy significantly influences the short-term course of the real economy.3 The precise amount remains open to debate. On t...
We study how changes in the value of the steady-state real interest rate affect the optimal infla... more We study how changes in the value of the steady-state real interest rate affect the optimal inflation target, both in the U.S. and the euro area, using an estimated New Keynesian DSGE model that incorporates the zero (or effective) lower bound on the nominal interest rate. We find that this relation is downward sloping, but its slope is not necessarily one-forone: increases in the optimal inflation rate are generally lower than declines in the steadystate real interest rate. Our approach allows us not only to assess the uncertainty surrounding the optimal inflation target, but also to determine the latter while taking into account the parameter uncertainty facing the policy maker, including uncertainty with regard to the determinants of the steady-state real interest rate. We find that in the currently empirically relevant region for the US as well as the euro area, the slope of the curve is close to -0.9. That finding is robust to allowing for parameter uncertainty.
I develop a version of the New Keynesian model with insideroutsider labor markets and hysteresis ... more I develop a version of the New Keynesian model with insideroutsider labor markets and hysteresis that can account for the high persistence of European unemployment. I study the implications of that environment for the design of monetary policy. The optimal policy calls for strong emphasis on unemployment stabilization which a standard interest rate rule fails to deliver, with the gap between the two increasing in the degree of hysteresis. A simple interest rule that includes the unemployment rate is shown to approximate well the optimal policy.
We study how changes in the steady-state real interest rate affect the optimal inflation target i... more We study how changes in the steady-state real interest rate affect the optimal inflation target in a New Keynesian DSGE model with trend inflation and a lower bound on the nominal interest rate. In this setup, a lower steady-state real interest rate increases the probability of hitting the lower bound. That effect can be counteracted by an increase in the inflation target, but the resulting higher steadystate inflation has a welfare cost in and of itself. We use an estimated DSGE model to quantify that tradeoff and determine the implied optimal inflation target, conditional on the monetary policy rule in place before the financial crisis. The relation between the steady-state real interest rate and the optimal inflation target is downward sloping. While the increase in the optimal inflation rate is in general smaller than the decline in the steady-state real interest rate, in the currently empirically relevant region the slope of the relation is found to be close to-1. That slope is robust to allowing for parameter uncertainty. Under "make-up" strategies such as price level targeting, the required increase in the optimal inflation target under a lower steady-state real interest rate is, however, much smaller.
Unconditional reduced form estimates of a conventional wage Phillips curve for the U.S. economy p... more Unconditional reduced form estimates of a conventional wage Phillips curve for the U.S. economy point to a decline in its slope coefficient in recent years, as well as a shrinking role of lagged price inflation in the determination of wage inflation. We provide estimates of a conditional wage Phillips curve, based on a structural decomposition of wage, price and unemployment data generated by a VAR with time varying coefficients, identified by a combination of long-run and sign restrictions. Our estimates show that the key qualitative findings from the unconditional reduced form regressions also emerge in the conditional evidence, suggesting that they are not entirely driven by endogeneity problems or possible changes over time in the importance of wage markup shocks. The conditional evidence, however, suggests that actual changes in the slope of the wage Phillips curve may not have been as large as implied by the unconditional estimates. Resumen Jordi Galí CREI, UPF and Barcelona GSE Luca Gambetti UAB and Barcelona GSE
We develop a utility based model of fluctuations, with nominal rigidities, and unemployment. In d... more We develop a utility based model of fluctuations, with nominal rigidities, and unemployment. In doing so, we combine two strands of research: the New Keynesian model with its focus on nominal rigidities, and the Diamond-Mortensen-Pissarides model, with its focus on labor market frictions and unemployment. In developing this model, we proceed in two steps. We first leave nominal rigidities aside. We show that, under a standard utility specification, productivity shocks have no effect on unemployment in the constrained efficient allocation. We then focus on the implications of alternative real wage setting mechanisms for fluctuations in unemployment. We then introduce nominal rigidities in the form of staggered price setting by firms. We derive the relation between inflation and unemployment and discuss how it is influenced by the presence of real wage rigidities. We show the nature of the tradeoff between inflation and unemployment stabilization, and we draw the implications for optimal monetary policy. JEL-code : E32, E50.
Recent evidence on the e ects of an exogenous increase in government spending on consumption cann... more Recent evidence on the e ects of an exogenous increase in government spending on consumption cannot be easily reconciled with existing optimizing business cycle models. We develop a simple dynamic model where the interaction of rule-of-thumb consumers and staggered price setting in goods markets can potentially account for that evidence.
Hysteresis and the European Unemployment Problem After twenty years of negligible unemployment, m... more Hysteresis and the European Unemployment Problem After twenty years of negligible unemployment, most of Western Europe has since the early 1970s suffered a protracted period of high and rising unemployment. In the United Kingdom unemployment peaked at 3.3 percent over the period 1945-1970, but has risen almost continuously since 1970, and now stands at over 12 percent. For the Common Market nations as a whole, the unemployment rate more than doubled between 1970 and 1980 and has doubled again since then. Few forecasts call for a significant decline in unemployment over the next several years, and none call for its return to levels close to those that prevailed in the 1950s and 1960s.
Journal of the European Economic Association, 2011
The standard New Keynesian model with staggered wage setting is shown to imply a simple dynamic r... more The standard New Keynesian model with staggered wage setting is shown to imply a simple dynamic relation between wage in ‡ation and unemployment. Under some assumptions, that relation takes a form similar to that found in empirical wage equations-starting from Phillips' (1958) original work-and may thus be viewed as providing some theoretical foundations to the latter. The structural wage equation derived here is shown to account reasonably well for the comovement of wage in ‡ation and the unemployment rate in the U.S. economy, even under the strong assumption of a constant natural rate of unemployment.
Most central banks perceive a trade‐off between stabilizing inflation and stabilizing the gap bet... more Most central banks perceive a trade‐off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade‐off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare‐relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence, is due to a special feature of the model: the absence of nontrivial real imperfections. We focus on one such real imperfection, namely, real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade‐off between stabilizing inflation and stabilizing the welfare‐relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interp...
We develop and estimate a structural model of inflation that allows for a fraction of firms that ... more We develop and estimate a structural model of inflation that allows for a fraction of firms that use a backward looking rule to set prices. The model nests the purely forward looking New Keynesian Phillips curve as a particular case. We use measures of arginal cost as the relevant determinant of inflation, as the theory suggests, instead of an ad-hoc output gap. Real marginal costs are a significant and quantitatively important determinant of inflation. Backward looking price setting, while statistically significant, is not quantitatively important. Thus, we conclude that the New Keynesian Phillips curve provides a good first approximation to the dynamics of inflation.
We study the international monetary policy design problem within an optimizing two-country sticky... more We study the international monetary policy design problem within an optimizing two-country sticky price model, where each country faces a short run tradeoff between output and inflation. The model is sufficiently tractable to solve analytically. We find that in the Nash equilibrium, the policy problem for each central bank is isomorphic to the one it would face if it were a closed economy. Gains from cooperation arise, however, that stem from the impact of foreign economic activity on the domestic marginal cost of production. While under Nash central banks need only adjust the interest rate in response to domestic inflation, under cooperation they should respond to foreign inflation as well. In either scenario, flexible exchange rates are desirable.
In this paper we provide evidence on the fit of the New Phillips Curve (NPC) for Spain over the m... more In this paper we provide evidence on the fit of the New Phillips Curve (NPC) for Spain over the most recent disinflationary period (1980-1998). Some of the findings can be summarized as follows: (a) the NPC fits the data well; (b) yet, the backward looking component of inflation is important; (c) the degree of price stickiness implied by the estimates
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Papers by Jordi Galí