Real Wage Rigidities and the New Keynesian Model

Olivier Blanchard () and Jordi Gali ()

No 5375, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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: inflation inertia; inflation targeting; monetary policy; oil price shocks (search for similar items in EconPapers)
JEL-codes: E32 E50 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac
Date: Written
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Related works:
Working Paper: Real wage rigidities and the New Keynesian model (2005)
Working Paper: Real Wage Rigidities and the New Keynesian Model (2005)
Working Paper: Real Wage Rigidities and the New Keynesian Model (2005)
Journal Article: Real Wage Rigidities and the New Keynesian Model (2007)
Journal Article: Real wage rigidities and the New Keynesian model (2005)
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