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Title:Real wage rigidities and the new Keynesian model PDF Logo
Authors:Blanchard, Olivier
Galí, Jordi
Issue Date:2005
Series/Report no.:Working paper series // Federal Reserve Bank of Boston 05-14
Abstract: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 interpretation for the dynamic inflation-unemployment relation found in the data.
Subjects:oil price shocks
inflation targeting
monetary policy
inflation inertia
JEL:E32
E50
Document Type:Working Paper
Appears in Collections:Working Paper Series, Federal Reserve Bank of Boston

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