Survey_BW_2009

Abstract

In the New-Keynesian model monetary aggregates play no direct role in the transmission of monetary policy to output and inflation. Monetary policy decisions are made with regard to the nominal interest rate. A change in the nominal rate affects the real interest rate because not all prices adjust flexibly and immediately. In its simplest form the model consists of two key equations, a forward-looking Phillips curve derived from the firms’ pricing problem under monopolistic competition and Calvo-style price rigidity, and an aggregate demand relation, the forward-looking IS curve, that is derived from the households’ intertemporal Euler equation. The linearized Phillips curve relation determines the deviation of inflation, denoted by ?t , from its steady-state, ?, as a function of expected future inflation, the output gap and cost-push shocks. The linearized version of the New-Keynesian IS curve then relates actual output, yt , defined as percentage deviation from steady state, to expected future output, the expected real interest rate and a demand shock. The real interest rate is defined as the difference between the short-term nominal interest rate, it, that is under the control of the central bank and expected inflation.