Expectations in the basic new keynesian model

Abstract

This paper analyses how the Basic New Keynesian Model from Galí (2008) responds to different settings for the way inflation expectations are constructed by agents in the model. Starting from a re-calibrated version of the original model -under rational expectations- and focusing particularly on the case in which monetary policy is run through a money growth rule, the goal is to compare how the impacts from both monetary and technology stochastic shocks mutate across different scenarios for inflation expectations. Particularly, the evolution of equilibrium dynamics and relevant variables' volatility are analyzed and compared when rational, extrapolative and adaptive processes rule the way inflation expectations are built in the economy. Interpreting how introducing extrapolative and adaptive expectations modifies the model output will allow us to conclude that the overall impact of both settings in the dynamic is similar. In summary, higher volatility is reported by the relevant variables in both scenarios. That is reflected on oscillating paths described by the variables post-shock, contrarily to the rational scenario. Moreover, both types of alternative expectations are introduced twice: first, on the way only firms form their inflation expectations (just modifying the New Keynesian Phillips Curve); and, secondly, on the way all agents in the economy estimate inflation (i.e. by also modifying the dynamic IS equation). Regarding this, we will conclude that, for the Basic New Keynesian Model under exogenous money supply with staggered price setting due to Calvo (1983), modifying inflation expectations for all the agents in the economy has no major implications than doing it only for the firms.