Paper #912

Title:

Real wage rigidities and the new Keynesian model

Authors:

Olivier Blanchard and Jordi Galí

Date:

April 2005 (Revised: October 2005)

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 non trivial 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.

Keywords:

Oil price shocks, inflation targeting, monetary policy, inflation inertia

JEL codes:

E32, E50

Area of Research:

Macroeconomics and International Economics

Published in:

Journal of Money, Credit, and Banking, supplement to vol. 39, nº1, 2007, 35-66

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