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The Extended Perturbation Method: New Insights on the New Keynesian Model

Martin M. Andreasen () and Anders Kronborg ()
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Martin M. Andreasen: Aarhus University and CREATES, Postal: Department of Economics and Business Economics, Fuglesangs Allé 4, 8210 Aarhus V, Denmark
Anders Kronborg: Danmarks Nationalbank and CREATES, Postal: Danmarks Nationalbank, Havnegade 5, 1093 Copenhagen K, Denmark

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: This paper introduces the extended perturbation method, which improves upon standard perturbation by removing approximation errors under perfect foresight. For the New Keynesian model, we show that standard perturbation generates explosive sample paths because it does not account for the upper bound on inflation as implied by Calvo pricing. In contrast, extended perturbation generates stable dynamics as it enforces this bound. Extended perturbation also adds to existing evidence on downward nominal wage rigidities in the New Keynesian model, as we only find support for this friction when using standard perturbation but not when using the more accurate extended perturbation approximation.

Keywords: Asymmetric wages; Extended Path; Perturbation method; Stable approximations (search for similar items in EconPapers)
JEL-codes: C62 C68 E30 (search for similar items in EconPapers)
Date: 2803
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