Working Paper: CEPR ID: DP5375
Authors: Olivier J. Blanchard; Jordi Gal
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
JEL Codes: E32; E50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| real wage rigidities (J31) | tradeoff between stabilizing inflation and welfare-relevant output gap (E63) |
| real wage rigidities (J31) | disruption of divine coincidence (Y80) |
| stabilizing inflation (E31) | larger decline in welfare-relevant output gap (D69) |
| real wage rigidities (J31) | variation in output gap in response to shocks (E39) |
| inflation dynamics influenced by supply and preference shocks (E31) | reevaluation of monetary policy strategies (E63) |