Real Wage Rigidities and the New Keynesian Model


  • Prepared for the FRB/JMCB conference on “Quantitative Evidence on Price Determination,” Washington, D.C., September 29–30, 2005. We have benefited from comments at various seminars and conferences, including CREI-UPF, Bank of England, MIT, LBS-MAPMU Conference, University of Oslo, NBER Summer Institute, Federal Reserve Board, New York Fed, Boston Fed, NYU, Princeton, Boston University, Harvard, and Boston College. We thank Marios Angeletos, Ray Fair, Jeff Fuhrer, Andy Levin, Greg Mankiw, Michael Woodford, our discussants Bob Hall and Julio Rotemberg, two anonmous referees, and the editor Ken West for useful comments. We are also grateful to Anton Nakov for excellent research assistance. We thank CREA-Barcelona Economics, MCyT Grant (SEJ 2005-01124), and the NSF, for financial help.


Most central banks perceive a trade-off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade-off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare-relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence, is due to a special feature of the model: the absence of nontrivial real imperfections. We focus on one such real imperfection, namely, real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade-off between stabilizing inflation and stabilizing the welfare-relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interpretation for the dynamic inflation–unemployment relation found in the data.