Resurrecting the New-Keynesian Model: (Un)Conventional Policy and the Taylor Rule

Abstract

This paper explores the ability of the New-Keynesian (NK) model to explain the recent periods of quiet and stable inflation at near-zero nominal interest rates. We show how (conventional and unconventional) monetary policy shocks enlarge the ability to explain the facts, such that the theory supports both a negative and a positive response of inflation. Central to our finding is that monetary policy shocks may have temporary and/or permanent components. We find that the NK model can explain the recent episodes, even if one considers an active role of monetary policy and restrict ourselves to the regions of (local) determinacy. We also show that a new global solution, capturing highly nonlinear dynamics, is necessary to generate a prolonged period of near-zero interest rates as a policy choice.

FTPL and the Maturity Structure of Government Debt in the New-Keynesian Model

“…In this section, we show how the FTPL mechanism outlined in Sims (2011) andCochrane (2018) is embedded in the continuous-time NK model (cf. Posch, 2020). For reasons of clarity, we shortly discuss the main channels of FTPL in the linear NK framework and abstract from the effects of uncertainty and nonlinearities.…”

“…paper, we focus on the expectation channel and abstract from other determinants such as risk premia and liquidity, an extension to include risk and term premia in the analysis is straightforward (cf. Posch, 2020). In particular we want to study the effects of temporary and permanent shocks on the term structure of interest rates.…”

Risk Matters: Breaking Certainty Equivalence

“…Following Posch (2018), the equilibrium can be alternatively defined in the space of states by simply using the equilibrium partial differential equations (PDEs) for the costate variables in ( 55) and ( 58). Together with the first order condition in (53) they form a system of non-linear functional equations in the unknown policy functions…”

Risk Matters: Breaking Certainty Equivalence

“…This section investigates the economic implications of the approximated solutions by measuring the pricing errors made when using the First-Order CE approximation, the First-Order approximation, and the Second-Order approximation defined in Section 3.1. The pricing mismatch is computed relative to a benchmark that is obtained using a global non-linear projection method based on a Chebyshev polynomial approximation of the unknown value function (see Parra-Alvarez, 2018;Posch, 2018). This approach delivers highly accurate solutions but is costly in terms of computational efficiency.…”

“…Zero-coupon bonds. To compute the price of a zero-coupon bond for a given time-tomaturity N we use the partial differential equation (PDE) approach (see Posch, 2018). Hence, in the absence of arbitrage opportunities, the fundamental price of a zero-coupon bond with maturity N , P…”