A central bank responds to a 1 percentage point increase in inflation by raising the nominal interest rate by 0.5 percentage points. According to the Taylor principle in the New Keynesian model, what does this imply?
AThis is sufficient — any positive nominal rate response to inflation stabilizes expectations
BThis violates the Taylor principle: the real interest rate falls, expectations are unanchored, and self-fulfilling inflation spirals become possible
CThis is excessive — the real interest rate should remain unchanged when inflation rises
DThe model is silent on the required magnitude of the central bank's response
The Taylor principle requires raising the nominal rate by more than one-for-one with inflation. A 0.5 percentage point nominal increase against 1 percentage point of inflation means the real interest rate (nominal minus expected inflation) actually falls, which is expansionary — it rewards inflation rather than punishing it. This failure to anchor expectations opens the door to indeterminacy: the system has multiple equilibria, and self-fulfilling inflation spirals become possible. Eigenvalue analysis shows that determinacy requires the number of unstable eigenvalues to equal the number of forward-looking variables — which requires a response coefficient greater than 1.
Question 2 Multiple Choice
Suppose the Calvo friction is removed from the New Keynesian model — all firms can reset prices every period. What happens to the model's predictions about monetary policy?
AMonetary policy becomes more powerful because prices adjust faster to accommodate the stimulus
BMonetary policy becomes neutral — output always equals its natural rate and a monetary expansion has no real effects
CThe model becomes indeterminate because prices are too flexible for the interest rate rule to stabilize
DInflation becomes permanently zero since all firms immediately reset to optimal prices
This is the model's central insight: monetary non-neutrality exists only because of price stickiness. Without the Calvo friction, a monetary expansion immediately causes all firms to raise prices proportionally. Real variables — the real interest rate, real output — are unchanged; only the nominal price level rises. The model collapses back to the RBC benchmark where money is neutral. The entire short-run output response to monetary policy is generated by the subset of firms that cannot yet adjust their prices. Remove stickiness, remove non-neutrality.
Question 3 True / False
The New Keynesian model predicts that a sustained monetary expansion can permanently raise real output above its natural rate.
TTrue
FFalse
Answer: False
The model predicts short-run but not long-run non-neutrality. A monetary expansion temporarily lowers real interest rates (because sticky prices prevent immediate full price adjustment), stimulating output above its natural rate. But as more firms gradually reset prices, the price level catches up with the monetary expansion, real interest rates return to their natural level, and output returns to its natural rate. Only nominal variables — the price level — are permanently affected. This long-run neutrality of money is a result shared with the classical tradition; what distinguishes the New Keynesian model is the transitional non-neutrality that makes monetary policy relevant in the short run.
Question 4 True / False
The New Keynesian Phillips Curve predicts that current inflation depends on expected future inflation, not only on current economic conditions.
TTrue
FFalse
Answer: True
The NKPC is forward-looking: πt = βEt[πt+1] + κỹt. Current inflation depends on expected future inflation (because firms setting prices today optimize over the entire period they may be stuck with that price, considering future marginal costs) and on the current output gap. This is a key difference from the traditional backward-looking Phillips curve, where inflation depended on past expectations. The forward-looking structure means credible monetary policy commitments — by shaping future inflation expectations — can reduce current inflation with smaller output costs than a purely backward-looking model would suggest.
Question 5 Short Answer
Explain why price stickiness — specifically the Calvo pricing friction — is what makes monetary policy non-neutral in the short run in the New Keynesian model.
Think about your answer, then reveal below.
Model answer: When a central bank eases monetary policy (cuts interest rates or increases money supply), prices would ideally adjust upward proportionally, leaving real variables unchanged — but Calvo pricing prevents this. Only a random fraction of firms get to reset prices each period; the rest are stuck with old prices. This creates a dispersion of prices: some firms have updated while others haven't, so the aggregate price level rises more slowly than the monetary expansion. As a result, real interest rates fall (nominal rates change faster than prices), stimulating demand and raising output above its natural rate. The non-neutrality is temporary: as more firms gradually reset prices over subsequent periods, the price level catches up and real variables return to natural levels. Without sticky prices, the price level would jump immediately and real variables would never deviate from natural levels.
The Calvo structure is particularly tractable because the probability of resetting is constant and independent of how long a firm has been stuck with its old price — no firm-specific state variable is needed. This produces the NKPC as a clean aggregate relationship. The deeper point is that the RBC model and the NK model share the same supply-side structure; the single addition of Calvo pricing is what turns a model where money doesn't matter into one where it does.