1
$\begingroup$

I am hoping for a simple intuition for why price stickiness induces indeterminacy of the interest rate, $i_t$, in the benchmark New Keynesian model. When prices are flexible, the natural rate is pinned down. However, it seems that price stickiness is the unique factor that breaks this. Is this correct?

I can do the pages of derivations and show to myself that $i_t$ is not uniquely determined without a policy rule, but in all that math I cannot see the economic intuition. I only see the math intuition of more variables than equations. I am missing the forest for the trees - I do not have an intuition for the core reason that introducing price stickiness makes $i_t$ indeterminate.

One thought I had is that since the firm problem becomes dynamic, and current price setting depends on future price setting that perhaps there is some sort of coordination indeterminacy? That doesn't seem correct to me though.

$\endgroup$

1 Answer 1

1
$\begingroup$

You may want to have a look at Galí's (2015) "Monetary Policy, Inflation, and the Business Cycle", Chapter 2. In a basic flex price model where the classical dichotomy holds, the nominal interest rate is not determined inside the model, only the real one. For any nominal interest the central bank can pick, expected inflation adjusts to obtain the (natural) real interest rate. Thus, even without sticky prices you need monetary policy to close the nominal side of the model. With sticky prices, the difference is that the classical dichotomy breaks down, and the real interest cannot be determined separately from the nominal one.

$\endgroup$
1
  • $\begingroup$ Great explanation, thank you. Also appreciate the reference. $\endgroup$
    – Debreu
    Feb 14 at 4:27

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.