1. New Keynesian economics Modern macroeconomic modeling

2. The science on monetary policy: a new Keynesian perspective, by Clarida, Gali, & Gertler, JEL 1999:4 How to conduct monetary policy? –empirical works demonstrated that monetary policy significantly influence short run real economy –development of theoretical framework in real business cycle literature –new class of macro models RBC: dynamic optimization framework explicit price rigidities or other frictions

3. A simple macroeconomic framework aggregate behavior derived from optimization of consumers and producers Woodford (1996) current behavior critically depends on expectations of future monetary policy flexibility of the model allow to accommodate different views on macroeconomy – RBC as useful benchmark

4. Notation

5. Model (no capital and investment)

6. “IS” curve Higher expected future output increases consumption today which lead to increase in aggregate demand –consumption smoothing motive intertemporal substitution of consumption is reflected by negative impact of the real interest rate –φ correspond to intertemporal elasticity of substitution

7. Phillips curve (aggregate supply) Pillips curve is derived based on price rigidity assumption (Calvo, 1983) Log-linear approximation about steady state of aggregation of individual firm pricing decision

8. “LM” curve interest rate i is an instrument of monetary policy, exogenous variable or

9. Policy objective

10. Optimal monetary policy under discretion

11. Result 1 There is a short run trade off between inflation and unemployment

12. Optimal monetary policy under discretion Result 2 The optimal policy incorporates inflation targeting to aim for convergence of inflation to its target over time Result 3 Optimal rule for nominal rate requires the coefficient on expected inflation exceed unity

13. Monetary policy under commitment: simple family of policy rules

14. Result 7 The solution under commitment perfectly resembles the solution under discretion that would assign a higher cost to inflation than the true social cost

15. Short history of macro Mankiw (2006) “The Macroeconomist as Scientist and Engineer,” NBER Working Paper No. 12349 Very few economists studied macroeconomic fluctuations before 1930’s: –D. Hume (1752) wrote on monetary policy –A. Pigou (1927) studied business cycles The Great Depression inspired economists to study aggregate economic variables to explain –Drop in output 31% –Unemployment 25% Term “Macroeconomics” first mentioned in 1940’s in works of F. Modigliani, P. Samuelson, R. Solow, J. Tobin

16. Keynesian approach Market are not always in equilibrium, prices are slow to adjust, consumers are myopic Main steps of development: –Formulated by Keynes in “The General Theory…” –Formally modeled by Hicks (1937), Modigliani (1944) aka IS-LM model –Various computational models based on the IS-LM model were widely used in 1960’s

17. Components of IS-LM model IS curve relates financial conditions and fiscal policies to GDP LM curve determines interest rates that equilibrate demand for money Phillips curve describes how price levels respond

18. New Classical Economic agents are rational and markets are always in equilibrium. Cycles are due to uncertainty, economic shocks, and bad government policies Main advancements of neoclassical approach –Monetarism, Friedman (1957) –Rational expectations, Lucas (1973, 1976) –Real business cycles, Kydland and Prescott (1982) Long and Plosser (1983)

19. New Keynesian Focus on price and wage rigidities, models are derived from microeconomic principles Main works –Systematic monetary policy has real impact Fisher (1977) –Model of inflation dynamics, Taylor (1980)

20. Who won? Empirical evidence shows that –Prices are slow to adjust –Real Business Cycles theories can not explain many of observed regularities But neoclassical models have more appeal from the theoretical point: –Based on microeconomic principles –Rational expectations Next step: new models based on utility maximization of economic agents, but introduce market imperfections.