Working Paper: NBER ID: w11806
Authors: Olivier 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. \n\tWe 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: New Keynesian Model; Real Wage Rigidities; Inflation; Output Gap
JEL Codes: E32; E50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| absence of real wage rigidities (F16) | divine coincidence (Z12) |
| real wage rigidities (J31) | breakdown of divine coincidence (Y60) |
| real wage rigidities (J31) | tradeoff between stabilizing inflation and stabilizing welfare-relevant output gap (E63) |
| real wage rigidities (J31) | inflation inertia (E31) |
| real wage rigidities (J31) | persistent effects on inflation (E31) |
| real wage rigidities (J31) | empirical relationship between inflation and unemployment (E31) |
| real wage rigidities (J31) | changes in inflation based on past inflation and expected future inflation (E31) |