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Title: Real Wage Rigidities and the New Keynesian Model

Author(s): Olivier J Blanchard and Jordi Galí

Publication Date: November 2005

Keyword(s): inflation inertia, inflation targeting, monetary policy and oil price shocks

Programme Area(s): International Macroeconomics

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.

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Bibliographic Reference

Blanchard, O and Galí, J. 2005. 'Real Wage Rigidities and the New Keynesian Model'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=5375