Research Discussion Papers, Bank of Finland
No 19/2002:
Reconciling the New Keynesian model with observed persistence
Kenneth Leong
Abstract: Despite sound theoretical foundations a drawback of the
New Keynesian model is its inability to generate adequate persistence in
the variables it seeks to explain. A common solution is to modify the model
to include lagged variables. However, this is unsatisfactory as many such
modifications depart from the microeconomic underpinnings of the original
model. This paper presents results from simulation exercises that support
the fully forward-looking New Keynesian model. In particular, we show that
the exchange rate channel of monetary policy, which has been largely
overlooked in existing studies of persistence, is instrumental in
generating inflation persistence. However, the combination of full
forward-looking behaviour and an open economy is unable to generate
sufficient persistence in the output gap. By including an autocorrelated
noise term to the assumption of rational expectations, the model is capable
of generating persistence that match those of US inflation, the output gap,
the nominal interest rate, as well as the real exchange rate.
Keywords: new Keynesian model; rational expectations; persistence; open economy; (follow links to similar papers)
JEL-Codes: E31; E52; (follow links to similar papers)
33 pages, September 3, 2002
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