Lecture 7: March 10, 2025

Monetary Policy in the New Kenesian Model

Macroeconomics EC2B1

Eran Yashiv

London School of Economics, WT 2024/2025

March 8, 2025
Plan: Ben Moll notes
1. Monetary policy
• already part of model, can use as is

2. Fiscal policy
• not in model yet, will have to extend it

3. Pecking order of monetary and fiscal policy?

Key observation: sticky prices break first welfare theorem

• sticky prices = “friction"
• ⇒ rationalizes some sort of policy intervention

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Monetary Policy in the New Keynesian Model

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What is central bank’s policy instrument? Money supply or interest rate?
• Recall: assume that central bank has two policy instruments
1. i1 : nominal interest rate between periods 1 and 2
2. M2 : money supply in period 2
• Usual description of monetary policy in media etc: interest rates
• why is monetary policy not only setting i1 ? Or (i1 , i2 )?
• Answer:
• in general, setting i and M are equivalent – see next slide
• in practice central banks announce i, adjust M accordingly
• but technical issue in our 2-period model: there is only one interest rate, i.e. no
i2 ⇒ need M2 in addition to i1
• note: not an issue in standard NK model because infinite horizon
• Related question: why not only ( M1 , M2 ) instead of (i1 , M2 )?
• this is equivalent, see next problem set
• Next slides: focus on i1 as central bank’s policy instrument
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Equivalence of setting i and M (from EC1B1)

Money Supply
• Modern economy: Central bank Nominal
Interest rate
can vary the money supply at
will
• In particular: Central Bank can i1

set money supply at each point i2

in time to achieve any interest
rate it desires
Md

M1 M2 Real Money
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Monetary policy affects consumption, investment, GDP

• Recall expressions for consumption, investment and GDP

( )σ
1 M2
C1 = A2
βA2 (1 + i1 ) P1
M2
I1 =
(1 + i1 ) P1
[ ( )σ ]
1 M2
Y1 = C1 + I1 = 1 + A2
βA2 (1 + i1 ) P1

• Clearly when central bank cuts interest rate i1 ↓, all of C1 , I1 , Y1 ↑

• Explain intuition in a few slides

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Monetary policy can stabilize recession caused by demand shock
[ ( )σ ]
1 M2
Y1 = 1 + A2 ↓ because A2 ↓ or β ↑
βA2 (1 + i1 ) P1

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Monetary policy can stabilize recession caused by demand shock
[ ( )σ ]
1 M2
Y1 = 1 + A2 ↑ because i1 ↓
βA2 (1 + i1 ) P1

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The monetary transmission mechanism: intuition
Looking at equations: central bank cutting nominal interest rate
i1 ↓ ⇒ C1 , I1 , Y1 , C2 , Y2 all ↑, P2 ↓
What’s going on under the hood, i.e. what’s transmission mechanism?
• i1 ↓⇒ real interest rate 1 + r1 = (1 + i1 ) P1 /P2 ↓
• r1 ↓⇒ household consumption C1 ↑ from Euler eqn C1 = C2 [ β(1 + r1 )]−σ (intertemporal
substitution)
• r1 ↓⇒ firm investment I1 = K2 ↑ from firm investment demand curve
• C1 ↑ and I1 ↑⇒ aggregate demand Y1D = C1 + I1 ↑
• Y1D ↑⇒ output Y1 ↑⇒ household income Ω = P1 Y1 ↑⇒ C1 , C2 ↑ (income effect) ⇒
aggregate demand Y1D ↑⇒ ... (Keynesian cross logic)
• K2 ↑⇒ future output Y2 = A2 K2 ↑ consistent with C2 ↑ (so that C2 = Y2 )
• C2 ↑⇒ price level P2 ↓ from quantity equation P2 C2 = M2
(one intuition: K2 ↑⇒ aggregate supply Y2S ↑⇒ price level P2 ↓)
• P2 ↓⇒ real interest rate 1 + r1 = (1 + i1 ) P1 /P2 ↑ until 1 + r1 = A2 so that capital market is
in equilibrium (recall infinitely elastic capital demand)
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Another way of looking at it: IS and MP curves
Recall IS and MP
316 curves
| Chapter 12 from EC1B1
Monetary Policy and
and the Phillips Curve standard textbooks (e.g. Jones)

The negative shock FIGURE 12.5

leads to a recession
as the economy moves Stabilizing the Economy after a Housing Bubble
from point A to point B.
Real interest rate, R Real interest rate, R

The Fed responds by

stimulating the economy
with lower interest
rates, moving output
back to potential as
B A B A
the economy moves r MP r MP
to point C.
C
R′ MP′
IS IS

IS ′ IS ′
!2% 0 ~ !2% 0 ~
Output, Y Output, Y
(a) (b)

~
Source: Jones, Macroeconomics
its initial point A to a point B, where output is below potential and Y is nega-
tive. (The 22 percent number shown in the graph is just chosen as an example.)
Now suppose that in response, the central bank lowers the nominal inter-
Here: IS and MP curves = just another way of plotting our equations
est rate. The stickiness of inflation ensures that the real interest rate falls as
well. As it falls below the marginal product of capital r , firms and households
take advantage of low interest rates to increase their investment. The higher 8
Another way of looking at it: IS and MP curves

• Recall expressions for consumption, investment and GDP

( )σ
1 M2
C1 = A2
βA2 (1 + i1 ) P1
M2
I1 =
(1 + i1 ) P1
[ ( )σ ]
1 M2
Y1 = C1 + I1 = 1 + A2
βA2 (1 + i1 ) P1

• Before: plotted Y1 as function of P1 , called it “aggregate demand"

• Now: plot Y1 as function of i1 , call it “IS curve"

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IS curve = Y1 plotted as function of i1

• Question for you: why the kink?

• Comment: usually IS(r) not i – would need extension with i1 affecting r1

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IS and MP curves

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A negative demand shock causes a recession

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Monetary policy can stabilize recession caused by demand shock

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 1+r 1+r

Figure 6.2.1 shows the solution to problem (6.2.5). As is standard in microeconomics, the household will

IS curve = Euler equation + investment demand curve choose the highest indierence curve it can aord, which implies that it will pick a point where the indierence

curve is tangent to the budget constraint. Notice two properties of the budget constraint. First, its slope is

• Will sometimes hear “New Keynesian IS curve"

− (1 + r)
(y , y )
. As usual, the slope of the budget constraint is the relative price.

steeper budget constraint. Second, the budget constraint goes through the point
Higher interest rates mean a

since the household

1 2

• Just another name for “Euler equation" and/or “investment demand curve"
280 | Chapter 11 The IS Curve has the option to just consume its income each period.

The IS curve captures FIGURE 11.1

the fact that high inter-
est rates reduce output Introducing the IS Curve
in the short run. This
Interest rate
occurs because high
interest rates make
borrowing expensive for
firms and households,
reducing their demand
for new investment. The
reduction in demand
leads to a decline in
output in the economy
as a whole.

The IS
curve

Fig. 6.2.1: The consumption-

Short-run output savings decision as a two-good
consumption problem.

• From Jones’ book: “The IS curve captures the fact that high interest rates reduce output in the short
11.2 Setting Up the Economy 5 We can also nd the solution to problem (6.2.5) from its rst order conditions. The Lagrangian is:

run. This occurs because

To develop high
a long-run model interest
of economic rates make
growth, we constructed borrowing expensive
a simple econ-  for firms and households,
1 1

omy and analyzed how that economy behaved. The result was a model that we L (c1 , c2 , λ) = u (c1 ) + βu (c2 ) − λ c1 + c2 − y1 − y2
could use to shed light on important economic questions. In the coming chapters, 1+r 1+r
reducing their demand for new investment. The reduction in demand leads to a decline in output in
we will do the same thing for the short-run model. 4
There is some disagreement about whether budget constraints should be written as equalities or as weak inequalities. I like
The IS curve is a key building block of the short-run model. We will
the version develop
with it
weak inequality because it says that the household could, in principle, not spend all its income. Since this never
the economy as a whole." as if it were its own “mini model.” The equation that serves as theanyway,
happens foundation
it's for
not a big deal which way we write it.
the IS curve is the national income identity that we first encountered
5
in Chapter
This problem 2:
is suciently simple that we don't need to use a Lagrangian to solve it. We could just as easily replace

• Jones is clearly talking about Euler equation and investment demand curve
Yt = Ct + It + Gt + EXt − IMt .
This equation shows that the economy’s output Yt can be used in one of four ways: as
(11.2)
107
consumption Ct , for investment It , for government purchases Gt , or for net exports
EXt − IMt . Although this is the traditional way of writing the equation, you 14
Optimal monetary policy and “divine coincidence"
• Question: what is the optimal monetary policy?
• Answer: the policy that
• undoes all distortions due to price stickiness
• equates allocation with sticky prices to that with flexible prices (first best
because welfare theorems hold)

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Optimal monetary policy and “divine coincidence"
• Specifically optimal monetary policy chooses i1 (or M2 ) to equate
[ ( )σ ]
sticky 1 M2
Y1 = 1+ A2 and Y1flex = A1 K1
βA2 (1 + i1 ) P1
• ⇒ optimal policy sets
M2 1
= ( )σ A 1 K1
(1 + i1 ) P1 1
1 + βA A
2
2

• Striking result: for any type and size of demand shock, there’s always a monetary
policy that can restore first-best allocation
• when responding to demand shocks, in this model, monetary policy faces no
tradeoff of any kind
• result is called “divine coincidence" (Blanchard and Gali, 2007)
https://en.wikipedia.org/wiki/Divine_coincidence
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Limits to monetary policy: zero lower bound (ZLB)
• Question: Is the optimal policy always feasible? Answer: no

• Definition: The zero lower bound (ZLB) is the requirement that nominal interest
rates cannot be negative, i1 ≥ 0

• Rationale:
• households and firms borrow and lend at rate i1
• but there’s an alternative to lending, namely holding money
• money always pays an interest rate of zero
• If i1 < 0, you’re better off putting your money under your mattress

• Alternative names for ZLB that mean same thing:

• effective lower bound (ELB), reason: bound may not be exactly = 0
• liquidity trap
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Limits to monetary policy: zero lower bound (ZLB)

18
Monetary policy cannot stabilize recession because ZLB binds

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Fiscal Policy in the New Keynesian Model

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Two main types of fiscal policy: G and T

1. Government spending G
• infrastructure projects,...
• the traditional way of thinking about fiscal policy

2. Transfers or tax cuts to households T

• tax cuts, stimulus checks, ...
• used in all U.S. recessions, same in many other countries
• in practice, probably the more important type of fiscal policy

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Introducing fiscal policy into the model
• Follow MW’s notation
• G1 , G2 : government spending
• T1 , T2 : lump-sum taxes, transfers = Tt < 0
• Key changes to model equations are as follows...
• Resource constraints
C1 + I1 + G1 = Y1 , C2 + G2 = Y2
• Household budget constraint
P2 C2 P2 (Π2 − T2 )
P1 C1 + = P1 (Π1 − T1 ) +
1 + i1 1 + i1
• Government budget constraint
P2 G2 P2 T2
P1 G1 + = P1 T1 +
1 + i1 1 + i1
• MW: G1 , G2 enter utility fn, here: G1 , G2 not valued (“digging ditches")
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Equilibrium with sticky prices and fiscal policy
( )σ
1 M2
C1 = A2
βA2 (1 + i1 ) P1
M2
C2 = A2
(1 + i1 ) P1
1 M2
I1 =
1 − g2 (1 + i1 ) P1
( )σ
1 + βA 1
2
A 2 ( 1 − g2 ) M2
Y1 = + G1
1 − g2 (1 + i1 ) P1
1 M2
Y2 = A2
1 − g2 (1 + i1 ) P1
1 + i1
P2 = P
A2 1

where g2 = G2 /( A2 K2 ) = share of G2 in potential output A2 K2

Note: equations are identical to MW’s equations (31)-(36)
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Fiscal policy via government spending G1

• Focus on effect of G1 on variables at t = 1

( )σ
1 M2
C1 = A2
βA2 (1 + i1 ) P1
1 M2
I1 =
1 − g2 (1 + i1 ) P1
( )σ
1 + βA 1
2
A 2 ( 1 − g2 ) M2
Y1 = C1 + I1 + G1 = + G1
1 − g2 (1 + i1 ) P1

• Clearly when G1 ↑, GDP Y1 increases one-for-one

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Government spending
( )
can stabilize recession caused by demand shock
σ
1+ 1
βA2 A 2 ( 1 − g2 ) M2
Y1 = + G1 ↓ because A2 ↓ or β ↑
1 − g2 (1 + i1 ) P1

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Government spending
(
can) stabilize recession caused by demand shock
σ
1+ 1
βA2 A 2 ( 1 − g2 ) M2
Y1 = + G1 ↑ because G1 ↑
1 − g2 (1 + i1 ) P1

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In this model fiscal multiplier is exactly 1
• Fiscal multiplier, more precisely government spending multiplier
∆Y1
Multiplier = = z, increase in GDP per z of government spending
∆G1
• All of C1 , I1 , C2 , ... do not depend on G1 and
Y1 = C1 + I1 + G1
• Therefore clearly
∆Y1
multiplier = =1
∆G1

• Intuition in Mankiw-Weinzierl’s words:

“The government-spending multiplier here is precisely one. An increase in government spending
puts idle resources to work and raises income. Consumers, meanwhile, see their income rise but
recognize that their taxes will rise by the same amount to finance that new, higher level of
government spending. As a result, consumption and investment are unchanged & the increase in
income precisely equals increase in government spending."
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In this model fiscal multiplier is exactly 1
∆Y1
multiplier = =1
∆G1
stands in contrast with other common hypotheses
• Crowding out of investment and private consumption

∆Y
Y = C + I + G with C, I ↓ ⇒ multiplier = <1
∆G
• Typical old Keynesian multiplier stories

∆Y
Y = C + I + G with C, I ↑ ⇒ multiplier = >1
∆G
• In a sense, multiplier = 1 is most natural and intuitive benchmark

• Should not expect multipliers either far < 1 or far > 1, e.g. 1/2 or 2
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Stabilization via G is only second-best
• Welfare effect of stabilization via G?

• Fiscal policy restores only first-best level of GDP Y1 but not C1 and I1
• C1 and I1 do not change when G1 ↑
• shortfall in private consumption C1 + I1 < A1 K1 is made up by public
consumption G1 ↑ such that C1 + I1 + G1 = A1 K1

• But households value G1 differently than C1

• in fact recall assumption: G1 , G2 not valued at all (“digging ditches")
• MW: more generally G1 ↑ distorts optimal mix of C1 and G1 :
“This fiscal policy is second-best, however, because it fails to produce the same allocation of
resources achieved under flexible prices. Public consumption will be higher in both periods, but
private consumption will be lower. As a result, households will end up with a lower level of
welfare."
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• Consider deficit-financed tax cut T1
• T1 ↓
• G1 , G2 unaffected
• require T2 ↑ for government budget constraint to hold

• Question 1: from expressions for equil’m variables, what is effect of T1 ↓?

( )σ
( )σ 1+ 1
A 2 ( 1 − g2 )
1 M2 βA2 M2
C1 = A2 , Y1 = + G1 , ....
βA2 (1 + i1 ) P1 1 − g2 (1 + i1 ) P1
• Question 2: what is the intuition?
• hint: “Ricardian equivalence"
• hint: present value P1 T1 + P2 T2
1+ i1 in household budget constraint

• Question 3: what is wrong with this result?

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Adding high MPC households: TANK model
Simplest way: “spender-saver model" of Campbell and Mankiw (1989)
• Fraction λ of households are “spenders" that consume their entire income, i.e. MPC=1

• Remaining fraction 1 − λ are “savers" that behave as before, i.e. maximize

U (C1sa ) + βU (C2sa ) subject to PV budget constraint

• Aggregate consumption is
sp
Ct = λCt + (1 − λ)Ctsa

Add this “spender-saver" structure to our New Keynesian model

• see supplement “Hand-to-Mouth Households (TANK Model)"

• makes model more consistent with empirical evidence (high MPCs)

This type of model: “TANK model" = Two Agent New Keynesian model
• a simplified version of the more complicated HANK models 30
Fiscal policy via transfers (“stimulus checks") in TANK model
• Presence of spenders λ > 0 breaks Ricardian equivalence

• Stimulus checks can now stabilize recession caused by demand shock

• Result: transfer multiplier for transfers to spenders is (γsp = income share)

∂Y1 λ
sp = >0
∂(− T1 ) 1 − λγsp
• Result: when there are high-MPC households (λ > 0), stimulus checks can restore the
flexible-price (first best) level of aggregate consumption C1
• not just GDP (as in case λ = 0)
• (though distribution C1sp vs C1sa differs from first-best)
• conjecture: combined with investment policies, can restore first-best aggregate
allocation completely (see Wolf paper in a few slides)
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Pecking Order of Monetary and Fiscal Policy?

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Pecking order of monetary and fiscal policy?

• When there is a recession, what type of stabilization policy should governments use?

• New Keynesian model implies clear pecking order: monetary policy preferable, only
use fiscal policy on rare occasions

• this is also the conclusion of Mankiw-Weinzierl

• More recent work (TANK and HANK models): it’s less clear

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New Keynesian model: clear pecking order of monetary and fiscal policy
• Monetary policy alone can restore first-best flexible-price allocation

• “divine coincidence"

• Only exception: if monetary policy is constrained by ZLB

• Fiscal policy is either second-best (G) or ineffective (T)

• Therefore

• monetary policy preferable

• only use fiscal policy on rare occasions (e.g. binding ZLB)

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More recent work: no clear pecking order

• When households have high MPCs and Ricardian equivalence breaks, there is no
longer such a clear pecking order

• Under some conditions, monetary and fiscal policy are exactly equivalent as far as
aggregate demand management is concerned

• Anything government can do with monetary policy can also be done with fiscal
policy and vice versa

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Congratulations, you’ve just caught up to the research frontier

• Forthcoming in the Journal of Political Economy

Source: https://economics.mit.edu/sites/default/files/2024-07/mpfp_equiv.pdf

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Sticky prices: summary and policy implications
(Contrast with analogous slide for flexible prices from Lecture 6)
• Sticky prices break monetary neutrality and the classical dichotomy

• Corollary: monetary policy affects real variables

• 1st welfare theorem breaks: some policy intervention is desirable

• Stabilization policy? When there is a recession due to shortfall in aggregate demand

• stabilization via fiscal policy is both possible and desirable
• stabilization via monetary policy is both possible and desirable unless ZLB binds
• no clear pecking order, use both depending on circumstances

• Role of central bank? control price level, stabilize recessions

• see e.g. mandate of U.S. Fed (“dual mandate")
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