The work of Discussion Paper No. 1404 is part of a relatively recent research agenda in which Jess Benhabib and Research Fellow Roger Farmer try to explain Keynesian features of modern economies within a dynamic intertemporal general equilibrium framework. Their explanations of Keynesian phenomena rest on the use of equilibrium models with many possible equilibria. For example, in their model an attempt to remove inflation from the economy may result in a sharp reduction in employment in the short term, but in a long-term increase in employment.

The main feature driving their results is that money is important because it is needed as a complementary input in the production process. An increase in the stock of money need not bid-up prices immediately, instead it may lead to a reduction in the interest rate that induces individuals to use more money in the process of exchange. Since money is complementary with other productive factors, its additional use stimulates output and employment without relying on disequilibria in any market. Instead, it relies on the idea that firms that increase their use of money in the short run, rationally anticipate an increase in future prices and, consequently, a reduction of the real value of money in the subsequent period. This leads to a sequence of levels of employment and output that converges back to a steady state. The issue of multiple equilibria is hereby resolved by arguing that individual beliefs are fundamentals of the economy, just like technology and preferences.

The Monetary Transmission Mechanism
Jess Benhabib and Roger E A Farmer