ISSN 2392-1641

Economics
and Business
Review
Volume 1 (15)Number
Volume 1 (15) Number 2 2015
2 2015

CONTENTS

ARTICLES
A perspective on leading and managing organizational change
Stanley J. Smits, Dawn E. Bowden
Alternative configurations of firm-level employment systems: evidence from American
companies
Bruce E. Kaufman, Benjamin I. Miller
How team leaders can improve virtual team collaboration through trust and ICT:
A conceptual model proposition
David Kauffmann
International trade in differentiated goods, financial crisis and the gravity equation
Udo Broll, Julia Jauer
Tax revenues and aging in ex-communist EU countries
Mihai Mutascu, Maciej Cieślukowski
The analytics of the New Keynesian 3-equation Model
Jean-Christophe Poutineau, Karolina Sobczak, Gauthier Vermandel
Investments and long-term real interest rate in Poland. Study of investment structure,
current account and their correlation with long-term real interest rates
Jakub Krawczyk, Szymon Filipczak

BOOK REVIEWS
Paweł Marszałek, Systemy pieniężne wolnej bankowości. Koncepcje cechy, zastosowanie
[Free Banking Monetary Systems. Concepts, Characteristics, Application], Wydawnictwo
Uniwersytetu Ekonomicznego w Poznaniu, Poznań 2014 (Bogusław Pietrzak)
Ewa Mińska-Struzik, Od eksportu do innowacji. Uczenie się przez eksport polskich
przedsiębiorców [From Export to Innovation – Learning by Exporting in Polish Enterprises],
Difin, Warszawa 2014 (Jan Rymarczyk)

Poznań University of Economics Press

Editorial Board
Ryszard Barczyk
Witold Jurek
Cezary Kochalski
Tadeusz Kowalski (Editor-in-Chief)
Henryk Mruk
Ida Musiałkowska
Jerzy Schroeder
Jacek Wallusch
Maciej Żukowski

International Editorial Advisory Board

Udo Broll – School of International Studies (ZIS), Technische Universität, Dresden
Wojciech Florkowski – University of Georgia, Griffin
Binam Ghimire – Northumbria University, Newcastle upon Tyne
Christopher J. Green – Loughborough University
John Hogan – Georgia State University, Atlanta
Bruce E. Kaufman – Georgia State University, Atlanta
Steve Letza – Corporate Governance Business School Bournemouth University
Victor Murinde – University of Birmingham
Hugh Scullion – National University of Ireland, Galway
Yochanan Shachmurove – The City College, City University of New York
Richard Sweeney – The McDonough School of Business, Georgetown University, Washington D.C.
Thomas Taylor – School of Business and Accountancy, Wake Forest University, Winston-Salem
Clas Wihlborg – Argyros School of Business and Economics, Chapman University, Orange
Jan Winiecki – University of Information Technology and Management in Rzeszów
Habte G. Woldu – School of Management, The University of Texas at Dallas

Thematic Editors
Economics: Ryszard Barczyk, Tadeusz Kowalski, Ida Musiałkowska, Jacek Wallusch, Maciej Żukowski •
Econometrics: Witold Jurek, Jacek Wallusch • Finance: Witold Jurek, Cezary Kochalski • Management and
Marketing: Henryk Mruk, Cezary Kochalski, Ida Musiałkowska, Jerzy Schroeder • Statistics: Elżbieta Gołata,
Krzysztof Szwarc
Language Editor: Owen Easteal • IT Editor: Piotr Stolarski

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Economics and Business Review, Vol. 1 (15), No. 2, 2015: 110–129
DOI: 10.18559/ebr.2015.2.6

The analytics of the New Keynesian

3-equation Model1

Jean-Christophe Poutineau2, Karolina Sobczak3,

Gauthier Vermandel4

Abstract: This paper aims at providing a self contained presentation of the ideas and
solution procedure of New Keynesian Macroeconomics models. Using the benchmark
“3 equation model”, we introduce the reader to an intuitive, static version of the model
before incorporating more technical aspects associated with the dynamic nature of the
model. We then discuss the relative contribution of supply, demand and policy shocks
to the fluctuations of activity, inflation and interest rate, depending on the key under-
lying parameters of the economy.
Keywords: dynamic IS curve, impulse response analysis, New Keynesian Macro­
economics, New Keynesian Phillips Curve, output gap, Taylor rule.
JEL codes: C63, E12, E32, E52.

Introduction
Keynesian ideas returned to the forefront of academic research in the mid 90’s
in new clothes to address questions related to unemployment, economic fluc-
tuations and inflation. This followed a twenty year period that witnessed the
domination of new classical ideas on both monetary and real macroeconom-
ics questions. Before contributing to the building of what is now considered
as the workhouse of modern macroeconomics [Carlin and Soskice 2014], the
New Keynesian School proposed in the 80’s a series of models aimed at provid-
ing microeconomic foundations to price and/or wage rigidity5 and at showing

1
Article received 15 April 2014, accepted 19 February 2015.
2
CREM-CNRS, University of Rennes 1, Faculty of Economics, 7 place Hoche, 35065 Rennes
cedex, France, corresponding author: [email protected].
3
Poznań University of Economics, Department of Mathematical Economy, Poznań, Poland.
4
CREM-CNRS, University of Rennes 1, Faculty of Economics, Rennes, France.
5
On New Keynesianism, its history, development and significance for modern economics,
see for example Bludnik [2009] or Romer [1993].
J.-C. Poutineau, K. Sobczak, G. Vermandel, The analytics of the New Keynesian  111

that this key feature of the real world can be explained in a setting with opti-
mizing agents with market power. An important breakthrough was about 15
years ago, with the papers of Goodfriend and King [1997] and Clarida, Gali,
and Gertler [1999]. These contributions introduced a framework mixing Real
Business Cycle features with nominal rigidities. This setting now forms the ba-
sic analytical structure of contemporaneous macroeconomic models as exem-
plified by Woodford [2003] or Gali [2008].
Besides new ideas and a  new modelling strategy this New Keynesian
Synthesis (NKS) has adopted new solution procedures that may appear cum-
bersome to non-specialists. Because of their recursive structure NKS models
do not admit a closed form solution but should be solved by borrowing proce-
dures developed for the analysis of stochastic discrete time dynamics systems.6
The aim of this paper is to provide a compact and self contained presentation of
the structure and of the standard solution procedure of the basic NKS frame-
work known as the “three equation model”. We particularly separate the main
ideas conveyed by this model, using a static version of the reference framework,
from the technical aspects of the solution procedure. In the presentation we
emphasise the qualitative similarities between the simple graphical analysis of
the static model and the Impulse Response Functions (IRFs) of the model fol-
lowing the occurrence of exogenous shocks. We then illustrate the key features
of this model regarding the analysis of business cycles characteristics.
The paper is organized as follows: In the first section we introduce the gen-
eral structure of a benchmark NKS model that combines (the log linear versions
of) a Philips curve, an Euler equation and a monetary policy (Taylor) rule.7 In
the second section we set a simple static version of the model to obtain closed
form solutions for the key macroeconomic variables and to provide the reader
with a graphical analysis of the consequences of demand and supply shocks.
In the third section we introduce the Blanchard-Kahn solution procedure to
get IRFs and dynamic reactions of the model around a stable steady state fol-
lowing exogenous supply demand and policy shocks. This third section is also
devoted to a discussion of business cycles characteristics of the model. Section
four concludes.

1. The 3 equation new Keynesian model

The New Keynesian Synthesis (NKS) mixes the methodology of Real Business
Cycles (RBC) with nominal and real rigidities to characterise short run macro-
economic developments. More particularly the NKS seeks to explain the mac-
roeconomic short run evolution of an economy subject to real and monetary

6
For an up to date exhaustive introduction to this literature see Miao [2014].
7
In the appendix we provide the micro foundations of the framework used in this paper.
112 Economics and Business Review, Vol. 1(15), No. 2, 2015

shocks and to replicate business cycle statistics. The core representation of this
synthesis has given rise to what is called the “3-equation model” as the basic
NKS setting reduces to a system of three equations corresponding to an AS-
AD model. First, the AS curve is represented by the New Keynesian Phillips
curve that relates inflation to the output gap. Second, the AD component of the
model combines a dynamic IS curve (that relates the evolution of the output
gap to the interest rate) and a MP (Monetary Policy) schedule (that describes
how the nominal interest rate is set by the central bank following fluctuations
in the output gap and in the inflation rate. This model is based on agents‘ mi-
cro founded decision rules where consumers maximize their welfare subject
to an intertemporal budget constraint and where firms maximize their profit,
subject to nominal rigidities, characterising the imperfect adjustment of pric-
es on the goods market. For convenience the micro foundations of this model
and the derivation of the log-linear system are presented in appendix. These
equations in turn determine three main variables of interest in a closed econ-
omy, namely the output gap ( yˆt) which is the gap between the effective output
and potential output, the inflation rate (πˆt) and the nominal interest rate (rˆt).
Formally, the model is defined as follows:
The New Keynesian Philips’ Curve (PC) links current inflation (πˆt) to ex-
pected future inflation (Et {πˆt +1}), to the current output gap ( yˆt) and to an ex-
ogenous supply shock that takes the form of a cost push shock (εtS):8

πˆt = βEt {πˆt +1} + κyˆ t + εtS. (1)

As shown in the appendix this relationship comes from the aggregation of

the supply decision of firms that have market power and can re-optimize their
selling price with discontinuities (i.e. nominal rigidities – they cannot modify
their selling price at any point in time). Thus they set the selling price of their
product depending on three main criteria. (i) The first criterion is anticipated
inflation: as firms cannot re-optimize their price, they take into account future
inflation to set their price today. (ii) The second term is the output gap: when
firms set their price they take into account the difference between supply and
demand so that inflation reflects stresses on the goods market: firms increase
their prices during periods of expansion ( yˆt > 0) whilst they decrease it during
recessions ( yˆt < 0). (iii) Finally, this relation incorporates a cost push term εtS
(such that εtS > 0 may indicate an increase in raw materials or energy price
in the economy). In a standard way we assume that εtS is an AR(1) process:9
εtS = ρ S εtS−1 + ηtS with ηtS ~ N (0, σ S2 ) and iid. The New Keynesian Phillips Curve is

8
In the paper all parameters are positive.
9
This assumption is commonly adopted in the literature to characterize exogenous shocks
[see for example, Gali 2008 for a discussion].
J.-C. Poutineau, K. Sobczak, G. Vermandel, The analytics of the New Keynesian  113

derived from the Calvo model [1983] which combines staggered price-setting
by imperfectly competitive firms. As presented in the appendix, the Calvo ap-
proach assumes that in each period, only a fraction θ of firms, randomly cho-
sen, can reset their selling prices10. Using this assumption, Clarida, Gali, and
Gertler [1999] show that the Phillips curve then takes a particularly simple
form in which inflation depends on the current gap between actual and equi-
librium output as in the standard Phillips curve but on expected future infla-
tion rather than on past inflation.
The dynamic IS curve is a log linearization of the Euler bond equation that
describes the intertemporal allocation of consumption of agents in the economy:

1
yˆ t = Et { yˆ t +1} − ( rˆ − Et {πˆt +1}) + εtD.
σ t
(2)

This relation plays the same role as the IS curve in the IS-LM model. As
shown in the appendix it comes from the intertemporal optimization of the
welfare index of a representative consumer subject to its budget constraint.
Once aggregated over consumers and log-linearized around the steady state
this relation can be expressed in terms of the output gap ( yˆt). The dynamic IS
curve links the current output gap to the difference between the real interest
rate (rˆt − Et {πˆt +1}), to the expected future output gap (Et { yˆ t +1}) and to an ex-
ogenous preference shock εtD (that represents a demand shock henceforth). The
demand shock is described in a standard way by AR(1) process of the form:
εtD = ρ D εtD−1 + ηtD with ηtD ~ N (0, σ D2 ) and is iid.
The Monetary Policy schedule (MP) is based on the Taylor rule. It links the
nominal interest rate (that is controlled by monetary authorities) to the infla-
tion rate and to the output gap:11

rˆt = ϕπ πˆt + ϕ y yˆ t + εtR. (3)

In this equation variable εtR denotes a monetary policy shock that follows
an AR(1) process of the form: εtR = ρ R εtR−1 + ηtR with ηtR ~ N (0, σ R2 ) and iid. This
shock identifies monetary policy decisions which imply deviations from the
standard Taylor rule such as unconventional measures or to reshape the infla-
tion expectations in the medium run. This MP schedule aims at replacing the
standard LM curve commonly found in the standard AS-AD model. It pro-
poses an up-to-date description of the behaviour of central banks that control
a short run nominal interest rate instead of a monetary aggregate [Clarida,
Gali, and Gertler 1999].

10
Baranowski et al. [2013] propose an endogenous mechanism.
11
In appendices, we provide an interest rate smoothing with smoothing parameter ρ. In this
section we neglect these features such that ρ = 0.
114 Economics and Business Review, Vol. 1(15), No. 2, 2015

This 3-equation model is a stylised shortcut that encompasses supply and

demand relations to determine how the three main macroeconomic variables
of interest (the output gap, the inflation rate and the nominal interest rate) react
to exogenous supply and demand shocks. In this short presentation we ignore
more recent developments associated with the introduction of financial fric-
tions that give rise to an acceleration phenomenon [see for example Poutineau
and Vermandel 2015a, b].

2. The solution to a static version of the model

This second section simplifies the previous system (1)–(3) to convey the main
ideas of the NKS model. Following Bofinger, Mayer, and Wollmershäuser [2006]
and Poutineau and Vermandel [2015b] we neglect the dynamic aspects of the
model and we concentrate on a static version of the framework.12 This is helpful
to obtain the reduced form for the main variables of interest and to understand
intuitions regarding the working of the model using tools similar to the IS-LM
and AD-AS frameworks. To obtain the static version of the model we firstly
assume that the monetary authorities are perfectly credible in the conduct of
monetary policy so that the private sector expects that they reach the targeted
inflation rate in future, namely that rˆt − Et {πˆt +1} = π0, where π0 is the long-run tar-
geted rate of inflation. Secondly, we assume that the economy is very close to
full employment so that the authorities are able to close the output gap in the
future, namely thatrˆt − Et {πˆt +1} = y0. Thus the gap between the real interest rate
and the natural interest rate disappears. In this case we can express the mon-
etary policy rule in terms of the real interest rate. Imposing these restrictions,
the simplified static framework gives:

π = π0 + κy + εS, (4)

y = y0 – σr + εD,(5)

r = ϕπ(π – π0) + ϕyy + εR.(6)

In equilibrium the values of the output gap y*, the inflation rate π* and the in-
terest rate r* solution to the model (4)–(6) are a linear combination of exog-
enous shocks:

y0 σϕ π S σ R 1 D
y* = − ε − ε + ε ,
Ω Ω Ω Ω
κ σκ R κ D Ω − κσϕ π S
12
Dynamic aspects will π −π0 = y0in−Section
be*reintroduced ε +3. ε + ε ,
Ω Ω Ω Ω

r* =
( )
ϕ πκ + ϕ y y0 ϕ πκ + ϕ y D ϕ π S 1 R
+ ε + ε + ε ,
Ω Ω Ω Ω
 π
y0 G. Vermandel,
J.-C. Poutineau, K. Sobczak, σϕ S σTheR analytics
1 D of the New Keynesian  115
y* = − ε − ε + ε ,
Ω Ω Ω Ω
κ σκ R κ D Ω − κσϕ π S
π * −π0 = y0 − ε + ε + ε ,
Ω Ω Ω Ω

r* =
( +
)
ϕ πκ + ϕ y y0 ϕ πκ + ϕ y D ϕ π S 1 R
ε + ε + ε ,
Ω Ω Ω Ω

where Ω = 1 + σ(ϕπκ + ϕ y).

The adjustment of the output gap, the inflation rate and the nominal inter-
est rate following alternative shocks is summarized in Table 1. As shown in
the first column a supply shock leads to a decrease in the output gap, (activ-
ity decreases below its natural level), and to an increase in the inflation rate
and in the interest rate. As shown in the second column a demand shock leads
to an increase in the output gap, (activity increases), in the inflation rate and
the interest rate. As observed, the reactions of the variables of interest to exo­
genous shocks are clearly affected by the value of the parameters of the inter-
est rate rule of the authorities (ϕπ and ϕ y).

Table 1. Reduced form of the static model

Supply Shock εS Demand Shock εD Monetary Shock εR

−σϕ π 1 −σ
Output gap ∂y / ∂ε <0 >0 <0
Ω Ω Ω

1 + σϕ y κ −σκ
Inflation ∂π / ∂ε >0 >0 <0
Ω Ω Ω

ϕπ ϕ πκ + ϕ y 1
Interest rate ∂r / ∂ε >0 >0 >0
Ω Ω Ω

To understand more clearly the reaction of the economy to supply and de-
mand shocks we refer the reader to figures 1 and 2. Graphically the model can
be represented as consisting of two panels: in the lower panel of each figure,
the IS-MP block (equations (5) and (6)) presented in the (y, r) space focuses
on demand side aspects and can be treated as a New Keynesian representa-
tion of the IS-LM framework; in the upper panel the AD-PC block presented
in the (y, π) space determines the global equilibrium of the economy and can
be treated as a New Keynesian representation of the AD-AS framework. The
PC curve is given by equation (4) and the AD curve is obtained by combining
equations (5) and (6) and is defined in equation (7),

y0 σϕπ 1
y= − (π − π0 ) + εtD.(7)
1 + σϕ y 1 + σ ϕ y 1 + σϕ y
116 Economics and Business Review, Vol. 1(15), No. 2, 2015

The consequences of the demand shock are presented in Figure 1. The first
panel displays the adjustment of the inflation rate and the output gap. The sec-
ond panel displays the adjustment of the demand side, accounting for the re-
action of the central bank to the shock.

π
PC

πC C
π0
A
AD’
AD
y0 yC yB y

r
MP’

rC C’ MP

B’
IS’
r0
A’
IS

y 0 yC yB y

Figure 1. Demand shock

To understand the main differences between the two panels one has just to
remember that the IS curve (5) moves one for one with a demand shock whilst
the demand curve moves by less than one. Thus, taking point A as the initial
equilibrium of the model a positive demand shock moves the IS curve from
IS to IS’ in the lower panel, which in turn, ignoring the reaction of the central
bank, moves the demand schedule to the dotted line. As the temporarily equi-
librium B implies an increase in the inflation rate the central bank reacts by
increasing the interest rate for any value of the output gap. Thus, the MP curve
in the lower panel moves left from MP to MP’. This, in turn, leads the aggre-
J.-C. Poutineau, K. Sobczak, G. Vermandel, The analytics of the New Keynesian  117

gate demand curve to move to the left from the dotted line to AD’. In the final
equilibrium C, the evolution of aggregate demand from AD to AD’, that com-
bines both the initial demand shock and the monetary reaction, is less than
proportional to the demand shock. Furthermore, with the reaction of the cen-
tral bank the increase of inflation is dampened. Finally the positive demand
shock leads to an increase in the output gap, an increase in inflation and a rise
in interest rate, as summarized in Table 1.

π PC’

PC

πB B
π0 A

AD
yB y0 y

MP’
MP

rB B’
r0 A’
IS

yB y0 y
Figure 2. Supply shock

The consequences of the supply shock are presented in Figure 2. In this ex-
ample the supply shock is a positive inflation shock (that corresponds to a de-
crease in the supply of goods ). Following this supply shock the Phillips curve
moves upwards to the left in the (y, π) space. This shock leads to an increase
in the rate of inflation and the central bank reacts by raising the interest rate.
Graphically the reaction of the central bank means increasing the interest rate
for any value of the output gap so that the MP curve moves left to MP’ in the
118 Economics and Business Review, Vol. 1(15), No. 2, 2015

lower panel of Figure 2. Once all the adjustments have been implemented the
final equilibrium lies at point B which is characterized by a negative output gap
(namely activity falls below its natural value), an increase of the inflation rate
over its targeted value and at point B’ an increase in the interest rate (needed
to dampen part of the inflation consequences of the supply shock).
Finally, the balance between the consequences of the shocks on activity and
inflation depends on the slope of the demand curve which, in turn, is affected by
the reaction of the central bank to inflation rate and output gap developments.
A more conservative central bank (namely a central bank that puts a higher
weight on inflation and a lower weight on the output gap) makes the slope of
the demand curve of the economy flatter in the upper panel of figures 1 and
2, which translates into lower fluctuations in the interest rate but to a higher
variability of the output gap. Conversely if the stance of the central bank reac-
tion is more sensitive to the output gap and less sensitive to inflation then the
MP and AD curves become steeper and shocks have a lower impact on activ-
ity and a higher impact on inflation.

3. The fully-fledged model

In the dynamic version of the model (1)–(3), each period t corresponds to
a quarter. As the fully fledged model does not have a closed form solution it
must be simulated around a stable steady state. The solution procedure, based
on the Blanchard-Kahn [1980] approach,13 requires the choice of numerical
values for the parameters of the model in order to compute Impulse Response
Functions (IRFs hereafter ) and the corresponding variance decomposition of
the three variables of interest of the model.

3.1. The solution procedure

The solution procedure introduced by Blanchard and Kahn [1980] is based
on matrix calculus and is aimed at selecting a unique stable dynamic path to
describe the reaction of the variables following the occurrence of exogenous
shocks. The Blanchard-Kahn condition defines a  necessary criterion to get
this result through the equality between the number of forward variables and
the number of unstable eigenvalues. Practically the problem of the eigenval-
ues translates into the problem of appropriate values of the structural param-
eters of the model or their combinations. To be solved the model first has to be

13
In this paper we adopted the Blanchard-Kahn approach for solving the model, given its
anteriority and popularity in literature. However, the reader should be aware of the existence of
other methods introduced by Klein [2000] and Sims [2000]. Miao [2014] offers a nice compari-
son between these three approaches.
J.-C. Poutineau, K. Sobczak, G. Vermandel, The analytics of the New Keynesian  119

written in a state-space representation. For our linear model (1)–(3), defining

Ξ = (σ + ϕ y + κ ϕ π )−1, this representation is:

 yˆ  Ξ σ 1 − βϕπ   Et { yˆ t +1} Ξ  − σεtS 

    t  =     +   . (8)
πˆt  βσ  σκ κ + β(σ + ϕ )  Et {πˆt +1} βσ  σβε t + βεt − βεt 
y D S R

The Blanchard-Kahn condition states that there are as many eigenvalues of

σ 1 − βϕ π 
the matrix ZT =  y 
greater than one in modulus as there are
 σκ κ + β(σ + ϕ )
non-predetermined variables. Since there are two forward-looking variables
in the model (1)–(3) ( yˆt and πˆt), we know that there should be exactly two ei-
genvalues outside the unit circle to get one unique stable trajectory of each of
the model’s variable around the steady state. Given the form of the matrix ZT ,
the Blanchard-Kahn condition for the model (1)–(3) reduces to the following
relation: κ(ϕπ – 1) + (1 – β)ϕy > 0.

Table 2. Calibration of parameters

Parameter Value Description

β 0.99 discount factor
σ 1 relative risk aversion
ε 6 elasticity of substitution amongst goods
φ 1 elasticity of marginal disutility with respect to labour
ϕπ 1.5 influence of inflation rate in the interest rate rule
ϕ y 0.5/4 influence of output gap in the interest rate rule
ρS 0.90 persistency of supply shock
D
ρ 0.90 persistency of demand shock
R
ρ 0.40 persistency of monetary policy shock
θ 3/4 probability of retaining old price
Source: Authors’ synthesis.

This condition reduces to the choice of appropriate values for the parameters
of the model. A sufficiently relevant condition for the previous one to be hold
is that the monetary authorities should respond more than proportionally to
inflation developments (namely, ϕπ > 1) according to the Taylor principle. In
this case a rise in inflation leads to a more than proportional rise in nominal
interest causing an increase in real interest rates that affects agents’ econom-
ic decisions and thus the real macroeconomic equilibrium of the model. The
120 Economics and Business Review, Vol. 1(15), No. 2, 2015

choice of parameters is therefore a main feature of the analysis as it must both

represent economic features and contribute to the Blanchard-Kahn condi-
tion. As presented in Table 2, following Galí [2008], we use a calibration of the
model parameters that is commonly selected in the literature. The intra-tem-
poral elasticity between intermediate goods is set at 6 which implies a steady
state mark-up of 20 % in the goods’ market corresponding to what is observed
in main developed economies. The sensitivity of the inflation rate to changes
in the marginal cost is equal to 0.13 roughly. The value of the discount factor
set at 0.99 implies the steady state quarterly interest rate equal to one and the
steady state real return on financial assets of about 4 percent per year. Average
price duration amounts to three quarters which is consistent with empirical
evidence.14 The values of coefficients in the interest rate rule (3) are consistent
with variations observed in the data on inflation and the interest rate given in
the annual rates.15 Because in our model periods are interpreted as quarters
the output gap coefficient has to be divided by 4.

3.2. Impulse-response analysis

The mechanisms by which random innovations change into endogenous vari-
ables fluctuations may be illustrated by impulse response functions (IRFs).
Each IRF isolates the impact of a particular shock throughout the economy. To
document the response of activity, inflation and nominal interest we sequen-
tially describe the consequences of a supply, demand and interest rate shock.
The demand shock: Figure 3 documents the consequences of a 1% positive
demand shock. As observed the increase in goods demand for leads to an in-

Benchmark regime is: ϕπ = 1.5, ϕ y = 0.5/4, inflation target regime: ϕπ = 1.7, output gap regime:
ϕ y = 0.8/4

Figure 3. Effects of a 1% demand shock

14
Galí, Gertler, López-Salido [2001] and Sbordone [2002] provide estimations based on ag-
gregate data. Galí [2008] points also to some micro evidence.
15
These values were originally proposed by Taylor [1999] as a good approximation of the
monetary policy conducted by the Federal Reserve in years 1986–1999 when the head of the
USA central banking system was Alan Greenspan. His monetary policy decisions largely fol-
lowed standard Taylor rule recommendations.
J.-C. Poutineau, K. Sobczak, G. Vermandel, The analytics of the New Keynesian  121

crease in activity so that the output gap becomes positive. However, as produc-
tion overshoots its natural value this rise in activity increases the inflation rate.
Since both the output gap and inflation rate increase the central bank should
react by raising the nominal interest rate.
According to the Taylor principle the nominal interest rate increases more
than proportionally to inflation developments to affect real exchange rates. This
policy however is not sufficient to close the positive output gap immediately or
to dampen the inflation rate. The effect of monetary policy should be assessed
over time on the output gap (activity goes back to its natural value as time pass-
es) and on the rate of inflation (that converges towards its natural value). The
adjustment time path is affected by the parameter value of the Taylor rule. As
presented in Figure 3 a higher concern for inflation or output gap reduces the
volatility of both activity and inflation. Thus, stricter monetary policy leads to
more moderate responses of variables to the demand shock.
The supply shock: Figure 4 represents the consequences of a 1% increase
in inflation (i.e. the negative supply shock acts as an increase in the price of
raw materials or energy that increases the real marginal cost of production).
This shock has a direct impact on inflation that rises and overshoots its tar-
geted value. As a consequence monetary authorities should react according to
the Taylor principle by raising the interest rate. Since the increase in the nom-
inal interest rate is higher than the rate of inflation, the real rate rises. This, in
turn, negatively affects output that decreases under its natural value. However,
as time passes, the increase in the interest rate dampens inflation. Finally, the
output gap goes back to its steady state value whilst the inflation rate reaches
its targeted value. As previously for the demand shock, the time path of vari-
ables is affected by the parameter values of the Taylor rule. A higher concern
for output gap (as represented with ‘inflation target’ IRF) leads to weaker re-
sponses of real variables and stronger responses of nominal variables. Inversely
a higher concern for inflation leads to stronger responses of real variables and
weaker responses of inflation and nominal interest rate.

Benchmark regime is: ϕπ = 1.5, ϕ y = 0.5/4, inflation target regime: ϕπ = 1.7, output gap regime:
ϕ y = 0.8/4

Figure 4. Effects of a 1% supply shock

122 Economics and Business Review, Vol. 1(15), No. 2, 2015

Benchmark regime is: ϕπ = 1.5, ϕ y = 0.5/4, inflation target regime: ϕπ = 1.7, output gap regime:
ϕ y = 0.8/4

Figure 5. Effects of 1% a monetary policy shock

The monetary policy shock: Figure 5 documents the consequences of a 1%

increase in the nominal interest rate (corresponding to a 25 basis point increase
in the exogenous shock measured in quarterly terms as presented in the fig-
ure). Because of sticky prices the initial increase in the nominal interest rate
implies a corresponding increase in the real interest rate at the initial period.
This depresses demand in the economy as it leads households to delay their
consumption through intertemporal consumption smoothing as reported in
the Euler condition. Since activity is demand determined, firms’ production
decreases. In the meanwhile the drop in demand generates deflation. The econ-
omy recovers overtime, since, according to the Taylor rule, a decrease in both
activity and in the inflation rate leads to a reduction in the nominal interest
rate after the initial period.

3.3. Business cycle statistics

IRF analysis aims at isolating the effect of a particular shock on the dynamics
of endogenous variables. However, in real life situations, shocks occur both
randomly and jointly to affect the macroeconomic equilibrium. The combined
effect of supply and demand shocks over time is captured by historical variance
analysis. The aim of this exercise is both to evaluate the relative contribution of
each type of shock on the motion of macroeconomic variables over time and to
appreciate how a particular design for economic policy may dampen the effect
of one particular type of shock. Table 3 shows the variance decomposition of
activity, inflation and the nominal interest rate under the benchmark calibra-
tion of Table 2 and evaluates the sensitivity of the benchmark results to alter-
native values of key behavioural and policy parameters of the model.
In the first panel of Table 3 (Benchmark calibration), supply side shocks
(namely price mark- up shocks) explain most of the output variability leaving
only a marginal contribution (around 4%) to demand and interest rate shocks.
In contrast the variability of the inflation rate is mainly explained by demand
and monetary policy innovations. Finally, around 2/3 of interest rate variabil-
ity is explained by real supply side shocks.
J.-C. Poutineau, K. Sobczak, G. Vermandel, The analytics of the New Keynesian  123

Table 3. Variance decomposition (in %)

Supply Demand Monetary Policy

1 – Benchmark
Production 95.93 3.16 0.91
Inflation 48.13 51.31 0.56
Interest rate 63.00 36.65 0.34
2 – Sticky economy θ = 0.95
Production 96.72 3.16 0.09
Inflation 99.07 0.76 0.17
Interest rate 99.02 0.08 0.00
3 – Quasi-flexible economy θ = 0.01
Production 90.84 2.99 6.17
Inflation 0.00 99.53 0.47
Interest rate 0.00 93.72 6.28
π
4 – Aggressive Monetary Policy ϕ = 2.5
Production 99.09 0.46 0.45
Inflation 39.81 59.36 0.83
Interest rate 62.49 36.36 1.15
y
5 – Output-oriented monetary policy ϕ  = 1
Production 96.02 3.16 0.82
Inflation 89.10 10.85 0.06
Interest rate 97.60 2.38 0.02

In panel 2 (sticky economy) and panel 3 (quasi flexible economy) we evalu-

ate the sensitivity of the benchmark results to alternative assumptions regarding
nominal rigidities. In the sticky economy only 5% of the total number of firms
can reset their price each period. Whilst in the quasi flexible situation 99% of
the total number of firms reset their prices each quarter. The main consequences
can be assessed with regard to the contribution of supply side shocks to infla-
tion and interest rates. Remarkably supply side shocks have no effect on either
inflation or interest rates when prices are flexible. In contrast the fluctuations
of the output gap are more sensitive to interest rate shocks whilst the effect of
demand shocks on activity is almost unobsevable.
In panel 4 and 5 we evaluate the sensitivity of the benchmark results to al-
ternative assumption regarding the conduct of monetary policy. When a mon-
etary policy is more aggressive in terms of inflation (panel 4) it dampens the
effect of demand shocks on activity (and in contrast makes output development
124 Economics and Business Review, Vol. 1(15), No. 2, 2015

more sensitive to supply shocks) and reinforces the impact of demand shocks
on inflation (whilst , conversely, it dampens the impact of supply side shocks
on this variable). Finally, this policy has almost no noticeable effect on the rela-
tive contribution of shocks on interest rate developments. In panel 5 an output
oriented monetary policy increases the effect of supply shocks on inflation and
interest rate whilst leaving the relative contribution of shocks on activity almost
unchanged. The results obtained in these last two panels may serve as simple
guideline to determine the nature of monetary policy depending on both its
objective and the origin of shocks. If an economy is mainly affected by price
mark-up shocks monetary policy should be more closely oriented towards out-
put developments. As this policy is able to dampen the effect of supply shocks
on inflation, whilst having no noticeable effect on activity, monetary authori-
ties are able to stabilise prices more easily. In contrast if the economy is affected
by demand shocks the authorities have to use arbitrage because a more aggres-
sive policy against inflation dampens the impact of demand shocks on activity
whilst it increases the impact of demand shocks on inflation.

Conclusions
In this paper we have described in a concise way the main ideas conveyed by
the 3 equation New Keynesian model and the main elements of the solution
procedure required to analyse the dynamics of the model. To introduce the
reader to this class of models we have presented a simple static version of the
model that gives both direct reduced forms and provides the basis for a sim-
ple graphical analysis of the macroeconomic equilibrium. We have then intro-
duced the Blanchard-Kahn solution procedure and report IRFs to describe the
dynamic adjustment of the economy over periods. Finally we have used the
historical variance analysis to evaluate how a modification of values of the key
parameters of the model affect the relative contribution of supply side and de-
mand side shocks. Our aim was not to provide the reader with a comprehen-
sive and up to date catalogue of all the results obtained by this New Keynesian
literature but rather to offer a clear and simple presentation of the basic ideas
and the required technical tools needed to solve this class of models that have
become the conventional workhorse of today’s macroeconomics.
J.-C. Poutineau, K. Sobczak, G. Vermandel, The analytics of the New Keynesian  125

Appendix

A. Micro-foundations
A.1. Households
There is a  continuum of households j ∈ [0; 1] with a  utility function
C1−σ H 1+φ
U (Ct , H t ) = t − χ t , the representative household maximizes its wel-
1− σ 1+ φ
fare, defined as the expected stream of utilities discounted by β ∈ (0, 1):
+∞
max Et ∑ β τU (Ct +τ ( j ), H t +τ ( j ) ).(A.1)
Ct ( j ), H t ( j ), Bt ( j )
τ =0

Under the budget constraint:

D
Pt Ct ( j) + e σεt Bt ( j) = Rt −1Bt −1 ( j) + Wt H t ( j),(A.2)

where σ > 0 and φ > 0 are shape parameters of the utility function with respect
to consumption and to labour supply whilst χ is a shift parameter which scales
the steady state labour supply to realistic values. As in Smets and Wouters [2005]
we introduce an AR(1) demand shock process in the budget constraint of the
D
representative household denoted by εt .
After replacing the Lagrange multiplier the first order conditions are defined
by the Euler bond condition:
σ
 C ( j)  β  R 
Et  t +1  = ε D Et  t  , (A.3)
 Ct ( j)  e t  πt +1 
Pt +1
where πt +1 = is the inflation rate and the labour supply equation is deter-
Pt
mined by:
Wt
χCt ( j)σ H t ( j)φ = .(A.4)
Pt

These equations define the optimal paths of labour and consumption and
maximize the welfare index of the representative household.
A.2. Firms
The representative firm i maximizes its profits:

max
H t (i ), Yt (i )
{Pt (i)Yt (i) − Wt H t (i)},(A.5)
126 Economics and Business Review, Vol. 1(15), No. 2, 2015

under the supply constraint:

Yt(i) = Ht(i). (A.6)

We suppose that firms solve a two-stage problem. In the first stage, firms choose
labour demand in a perfectly competitive market. The first order condition is:

Wt
MCt (i) = MCt = , (A.7)
Pt

where MCt denotes the nominal marginal cost of producing one unit of goods.
In the second stage problem the firms cannot optimally set prices. There
is a fraction of firms θ that are not allowed to reset prices. Prices then evolve
according to Pt(i) = Pt – 1(i). The remaining share of firms 1 – θ can set their
selling price such that Pt(i) = Pt*(i), where Pt*(i) denotes the optimal price set
by the representative firm given the nominal rigidity. The maximization pro-
gramme is thus defined as:

+∞
λct +τ
max Et ∑ c
(βθ )τ Pt*(i) − MCt +τ (i)Yt +τ (i), (A.8)
τ =0 λt
Pt*(i )

under the downward sloping constraint from goods’ packers:

 μ
− t +τ 

 tP* (i )  μt +τ −1

Et {Yt +τ (i)} = Et   Yt +τ  ,   τ > 0, (A.9)
P
 t +τ  
 
where:
 S
μt = e γεt – the time-varying mark-up,
 −1
 – denotes the imperfect substitutability between different goods
varieties,
εtS – denotes the mark-up shock,
γ – a shift parameter that normalizes the shock to unity in the
log-linear form of the model as in Smets and Wouters [2005].
Since firms are owned by households they discount the expected profits us-
ing the same discount factor as households (βτλt+τ c
/λt c). The first order condi-
tion is thus:

+∞
λct + τ ( βθ )τ
Et ∑ c
 Pt*(i) − μt +τ MCt +τ (i) Yt +τ (i) = 0. (A.10)
τ =0 λt μt + τ − 1
J.-C. Poutineau, K. Sobczak, G. Vermandel, The analytics of the New Keynesian  127

A.3. Authorities
To close the model the monetary policy authority sets its interest rate accord-
ing to a standard Taylor Rule:
1− ρ
Rt  Rt    πt   Yt  
π y
ρ ϕ ϕ
R
=        e εt , (A.11)
R  R   π   Y  
 

where:
Rt – the nominal interest rate,
πt – the inflation rate,
Yt – the level of output,
εRt – an AR(1) monetary policy shock.
Finally, parameters R, π and Y are steady state values for the interest rate,
the inflation rate and GDP16. The central bank reacts to the deviation of the
inflation rate and the GDP from their steady state values in a proportion of
ϕπ and ϕ y, the central bank also smoothes its rate in a proportion of degree ρ.
A.4. Equilibrium conditions
After aggregating all the supplies by firms the resource constraint for the econ-
omy is defined by:

Yt = Ct.(A.12)

Whilst the aggregation between constrained firms and non-constrained firms

leads to the following equation for aggregate prices:
1 1 1
1− μt 1− μt 1− μt
(Pt ) = θ (Pt −1 ) + (1 − θ )(Pt*) . (A.13)

B. Linearization
To obtain the steady state of the model, we normalize prices i.e. P = 1 whilst
we assume that households work one third of their time H = 1/3. Then we find:

C = Y = H,
1
W = MC = ,
μ
χ = WC − σ H − φ . 

16
Under a credible central bank, π and Y also can be interpreted as the targets of the cen-
tral bank in terms of inflation rate and GDP.
128 Economics and Business Review, Vol. 1(15), No. 2, 2015

First, combining the Euler bond equation (A.3) and the resources constraint
(A.12), i.e. yˆ t = cˆt, we get production determined by:

1
yˆ t = Et yˆ t +1 − ( rˆ − Et πˆt +1 ) + εtD.(A.14)
σ t

The labour supply equation (A.4) in log-deviation is:

wˆ t = σcˆt + φhˆt,(A.15)

where wˆ t denotes the variations of the real wage. Up to a first order approxi-
mation of the firm price optimization solution (A.10) and the aggregate price
equation (A.13), the linearized new Keynesian Phillips curve is:

(1 − θ )(1 − θβ)
πˆt = βEt πˆt +1 + ˆ t + εtS.(A.16)
mc
θ

Thus the real marginal cost is: mc ˆ t = wˆ t and the production function yt = ht,
then from the labour supply equation, the marginal cost can be simplified as:
mcˆ t = (σ + φ) yˆt. Then the Philips curve is:

(1 − θ )(1 − θβ)
πˆt = βEt πˆt +1 + (σ + φ) yˆ t + εtS.(A.17)
θ

Finally, the monetary policy is determined by:

( )
rˆt = ρrˆt −1 + (1 − ρ ) ϕ π πˆt + ϕy yˆ t + ε tR.(A.18)

To summarize, our model is determined by the following set of three equations:

 1
 yˆ t = Et yˆ t +1 − ( rˆt − Et πˆt +1 ) + εtD ,
σ

 (1 − θ )(1 − θβ)
 πˆt = βEt πˆt +1 + (σ + φ) yˆ t + εtS ,
 θ
( )
rˆt = ρrˆt −1 + (1 − ρ) ϕπ πˆt + ϕy ˆyt + ϕΔy ( ˆyt − ˆyt −1 ) + εtR .


Where shock processes are determined by:

εti = ρi εti −1 + ηti , i = D, S, R.(A.19)

J.-C. Poutineau, K. Sobczak, G. Vermandel, The analytics of the New Keynesian  129

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Economics and Business Review (E&BR) is published quarterly and is the successor to the Poznań University of Economics
Review. The E&BR is published by the Poznań University of Economics Press.
E&BR is listed in ProQuest, EBSCO, and BazEkon.
Subscription rates for the print version of the E&BR: institutions: 1 year – €50.00; individuals: 1 year – €25.00. Single copies:
institutions – €15.00; individuals – €10.00. The E&BR on-line edition is free of charge.
Correspondence with regard to subscriptions should be addressed to: Księgarnia Uniwersytetu Ekonomicznego w Poznaniu,
ul. Powstańców Wielkopolskich 16, 61-895 Poznań, Poland, fax: +48 61 8543147; e-mail: [email protected].
Payments for subscriptions or single copies should be made in Euros to Księgarnia Uniwersytetu Ekonomicznego w Poznaniu
by bank transfer to account No.: 96 1090 1476 0000 0000 4703 1245.