New Keynesian Microfundations Revisited: A Generalised Calvo-Taylor Model and the Desirability of Inflation vs. Price Level Targeting

Jul 2002 | 109

Authors: Richard Mash

Optimal monetary policy is sensitive to the Phillips curve specification used to represent the dynamics of inflation and output. Most recent literature has used a new Keynesian Phillips Curve based on Calvo pricing. This paper shows that this workhorse model is not robust to relatively minor changes in its microfoundations, in particular allowing for time varying probabilities of a firm being able to reset its price. We derive a general model that nests Calvo and the Taylor staggering model as special cases and analyse its implications for optimal policy, including the relative desirability of inflation and price level targeting.

JEL Codes: E52, E58, E22, C61

Keywords: New Keynesian Phillips Curve, Stabilisation Bias, Forwarding Looking Expectations, Inflation Targeting, Price Level Targeting

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