What is the New Keynesian DSGE Model?

The New Keynesian DSGE model is underpinned by three fundamental equations, each crucial for understanding macroeconomic dynamics. Firstly, the Phillips curve embodies the trade-off between inflation and real economic activity, capturing how changes in economic output affect price levels. Secondly, the IS curve depicts the relationship between output and interest rates, reflecting the equilibrium in the goods market and the impact of monetary policy on economic activity. Lastly, the Taylor rule outlines the central bank’s reaction function, dictating how it adjusts the nominal interest rate in response to deviations of inflation from its target and output from its potential. Mastery of these equations is paramount for grasping the intricate interplay between monetary policy, inflation dynamics, and output fluctuations, providing a solid foundation for analyzing economic phenomena and guiding policy prescriptions. In this article, we will talk about the three equations that define the canonical model, and at the end of the article, you will find a link to join a hands on webinar in Stata. Through this webinar, participants will gain comprehensive insights into these equations, learning not only how to estimate them in Stata but also how their variables and parameters influence one another, facilitating a deeper understanding of macroeconomic theory and practice. 

New Keynesian DSGE Model Introduction

The New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model stands as a cornerstone in modern macroeconomic analysis, offering a nuanced understanding of how economies behave over time. Unlike its neoclassical predecessor, this model incorporates the insights of Keynesian economics, recognizing the presence of nominal rigidities such as sticky prices and wages. By acknowledging these imperfections, the New Keynesian DSGE model unveils a more realistic portrayal of economic dynamics, particularly in the short run. At its core, the model delves into the intricate interactions between households, firms, and policymakers, capturing how shocks ripple through the economy and shape variables like output, employment, and inflation. With its emphasis on rational expectations and optimizing behavior, alongside the pivotal role of monetary policy, this framework enables economists and policymakers to dissect various policy interventions and assess their implications for macroeconomic stability.

The Canonical Three Equations New Keynesian DSGE Model

The canonical three-equation New Keynesian DSGE model is a simplified version of the broader New Keynesian DSGE framework. It consists of three key equations that capture the dynamics of the economy:

1. Output Gap Equation: The output gap equation describes how the output gap evolves over time. It states that the current output gap (y) depends on the expected future output gap, the nominal interest rate (r), the expected future inflation (E(π)), and exogenous shocks (u). The parameter θ represents the degree of price stickiness, indicating how quickly prices adjust to changes in the output gap. 

2. New Keynesian Phillips Curve: The Phillips curve represents the relationship between inflation (π), the output gap (y​), and the expectations operator (E). It suggests that inflation depends on the expected future level of inflation, the current output gap (the difference between actual and potential output), and exogenous shocks (e). The parameter β represents the degree to which agents incorporate future expectations into their current decisions, while κ measures the sensitivity of inflation to changes in the output gap. 

3. Monetary Policy Rule: The monetary policy rule governs how the central bank sets the nominal interest rate (r) in response to inflation (π), the output gap (y), and the expectations operator (E). It suggests that the central bank adjusts the nominal interest rate based on its inflation target and the deviation of output from its potential level. The parameters ψ and ψi​ represent the sensitivity of the central bank's interest rate policy to changes in inflation and the output gap, respectively. Exogenous shocks (v) may also affect the central bank's decision-making process.