NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Real Wage Rigidities and the New Keynesian Model

Olivier Blanchard, Jordi Gali

NBER Working Paper No. 11806
Issued in November 2005
NBER Program(s):   EFG   ME

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 non trivial 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.

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Document Object Identifier (DOI): 10.3386/w11806

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