Optimal Monetary Policy in a New Keynesian Forward-Looking Model
This paper examines optimal monetary policy within the framework of the New Keynesian forward-looking model. It reviews the theoretical context of New Keynesian economics, including its departure from real business cycle thinking through the incorporation of sticky prices, rational expectations, and microeconomic foundations. The paper outlines the model's core assumptions, presents the New Keynesian Phillips curve structure, and discusses robust optimal policy rules. A central focus is the concept of "divine coincidence"—the property that stabilizing inflation simultaneously stabilizes the output gap—and how the introduction of real wage rigidities undermines this property. Finally, the paper addresses the implementation of optimal monetary policy as a constrained optimization problem, drawing on research by Dotsey, Hornstein, Giannoni, Woodford, and others.
- Introduction: Overview of paper scope and objectives
- Context: New Keynesian Economics: Origins and features of New Keynesian model
- Assumptions of the Model: Inflation and output-gap stabilization assumptions
- Structure of the Model: Phillips curve equation and robust policy rules
- The Issue of Divine Coincidence: When inflation and output-gap stabilization align
- Implementation of Optimal Monetary Policy: Full-commitment vs. Markov-perfect policy rules
- Conclusion: Summary of research findings and implications
✍️ How to write this paper — guide, tools & examples ▾
What makes this paper effective
- It grounds abstract monetary theory in a concrete model structure, presenting the New Keynesian Phillips curve equation alongside verbal explanation, which aids comprehension for readers at multiple levels.
- It draws on a diverse set of primary sources—Blanchard and Gali, Dotsey and Hornstein, Giannoni, Woodford—to build a coherent, multi-perspective argument rather than relying on a single authority.
- The paper traces a logical progression from theoretical context through model assumptions, structure, a key theoretical property (divine coincidence), and finally practical implementation, giving the review clear direction.
Key academic technique demonstrated
The paper demonstrates integrative literature synthesis: rather than summarizing each source separately, it weaves findings from multiple economists into a single evolving argument about why the divine coincidence breaks down and what that means for policy implementation. This technique is especially evident in the divine coincidence section, where Blanchard and Gali's framework is used to anchor contributions from several supporting sources.
Structure breakdown
The paper opens with a brief introduction stating its purpose and scope. The main body is organized into four thematic sections: (1) the New Keynesian context, tracing the model's intellectual lineage; (2) the model's assumptions regarding inflation and output-gap stabilization; (3) the formal model structure, centered on the New Keynesian Phillips curve and robust policy rules; and (4) the divine coincidence property and its collapse under real wage rigidities. An implementation section then discusses full-commitment versus Markov-perfect policy rules. The conclusion is noted as incomplete in the source.
Introduction
A number of monetary policies have been developed in recent years with a view to accurately predicting economic trends and patterns. In addition, a new standard Keynesian model has emerged in the area of macroeconomics that focuses on the topic of optimal monetary policy in a simple forward-looking model. To determine an optimal monetary policy in a simple forward-looking model in the context of this New Keynesian framework, this paper reviews the relevant literature to explain the model's assumptions, its structure, the issue of "divine coincidence," and the implementation of optimal monetary policy. A summary of the research and important findings is presented in the conclusion.
Works Cited
Blanchard, Olivier and Jordi Gali. "Real Wage Rigidities and the New Keynesian Model." Journal of Money, Credit & Banking 39.1 (2007): 35–7.
Dotsey, Michael and Andreas Hornstein. "Implementation of Optimal Monetary Policy." Economic Quarterly (Spring 2006): 113–34.
Ghosh, A. R. "Is it Signaling? Exchange Intervention and the Dollar-Deutschmark Rate." Journal of International Economics 54 (1992): 439–53. Cited in Sarno and Taylor, p. 57.
Giannoni, M. P. "Robust Optimal Monetary Policy in a Forward-Looking Model with Parameter and Shock Uncertainty." Journal of Applied Econometrics 22 (February 2006): 179–213.
Jondeau, Eric and Hervé Le Bihan. "Evaluating Monetary Policy Rules in Estimated Forward-Looking Models." Annals of Statistics and Economics 67/68 (2002): 357–363.
Knoop, Todd A. Recessions and Depressions: Understanding Business Cycles. Westport, CT: Praeger, 2004.
Leeper, Eric M. "Optimal Monetary Policy in Simple Models." Indiana University and NBER, 12 May 2005.
Roberts, John M. "New Keynesian Economics and the Phillips Curve." Journal of Money, Credit & Banking 27.4 (1995): 975–77.
Rotheim, Roy J. New Keynesian Economics/Post Keynesian Alternatives. London: Routledge, 1998.
Sarno, Lucio and Mark P. Taylor. The Economics of Exchange Rates. Cambridge, England: Cambridge University Press, 2002.
Snowdon, Brian and Howard R. Vane. A Macroeconomics Reader. London: Routledge, 1997.
Woodford, M. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University Press, 2003.
Create your account
Always verify citation format against your institution’s current style guide requirements.