New Keynesian Macro in graphs!

In honor our our current posterboy (Larry Meyer), I am happy to blog about a new NBER working paper by Pierpaolo Benigno titled "New Keynesian Economics: An AS-AD View".

Sadly I can't find an ungated version, so I will quote at length from the introduction:

This work presents a simple New-Keynesian model illustrated by Aggregate Demand (AD) and Aggregate Supply (AS) graphical analysis. In its simplicity, the framework features most of the main characteristics emphasized in the recent literature. The AD and AS equations are derived from an intertemporal model of optimizing behavior by households and firms respectively.

The AD equation is derived from households’ decisions on intertemporal consumption allocation. A standard Euler equation links consumption growth to the real interest rate, implying a negative correlation between prices and consumption. A rise in the current price level increases the real interest rate and induces consumers to postpone consumption. Current consumption falls.

The AS equation derives from the pricing decisions of optimizing firms. In the
long run, prices are totally flexible and output depends only on real structural factors. The equation is vertical. In the short run, however, a fraction of firms keep prices fixed at a predetermined level, implying a positive relationship between other firms’ prices, which are not constrained, and marginal costs, proxied by the output gap. The AS equation is a positively sloped price-output function.

As in Keynesian theory, the model posits some degree of short-run nominal rigidity. Nominal rigidity can be explained by the fact that price setters have some monopoly power, so that they incur only second-order costs when they do not change their prices. In the long run, the model maintains the classical dichotomy between the determination of nominal and real variables, with a vertical AS equation.

The analysis is consistent with the modern central banking practice of targeting
short-term nominal interest rates, not money supply aggregates. The mechanism of transmission of interest rate movements to consumption and output stems from the intertemporal behavior of the consumers. By moving the nominal interest rate, monetary policy affects the real interest rate, hence consumption-saving decisions.

This simple framework allows us to analyze the impact of productivity or mark-up disturbances on economic activity and to study alternative monetary and fiscal policies. In particular, we can analyze how monetary policy should respond to various shocks. That is, a microfounded model yields a natural objective function that monetary policy could follow in its stabilization role, namely the utility of consumers. This objective is well approximated by a quadratic loss function in which policymakers are penalized, with certain weights, by deviating from a price-stability target and at the same time by the fluctuations of output around the efficient level. In the AS-AD graphical plot, optimal policy simplifies to just an additional curve (labelled IT for “Inflation Targeting”)

seems pretty cool. Here is an interesting tidbit given our current policy debates:

The impact of the fiscal multipliers on output and the output gap can be quantified showing that a short-run increase in public spending has a multiplier less than one on output and a much smaller multiplier on the output gap.

Uh-oh!