DP13384 Continuous Time Versus Discrete Time in the New Keynesian Model: Closed-Form Solutions and Implications for Liquidity Trap

Author(s): Lilia Maliar
Publication Date: December 2018
Date Revised: December 2018
Keyword(s): closed-form solution, continuous time, forward guidance, New Keynesian Model, ZLB. liquidity trap
JEL(s): C61, C63, C68, E31, E52
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13384

Economists often use interchangeably the discrete- and continuous-time versions of the Keynesian model. In the paper, I ask whether or not the two versions effectively lead to the same implications. I analyze several alternative monetary policies, including a Taylor rule, discretionary interest rate choice and forward guidance. I show that the answer depends on a specific scenario and parameterization considered. In particular, in the presence of liquidity trap, the discrete-time analysis helps overcome some negative implications of the continuous-time model, such as excessively strong impact of price stickiness on inflation and output, unrealistically large government multipliers, as well as implausibly large effects of forward guidance.