Sticky prices and the policy rate

This is the account that most central banks build their analysis on, which makes it the one a reader is most likely to meet without being told its name. It is also the framework the previous lesson's machinery was borrowed for.

The structure, in plain terms

Clarida, Gali and Gertler's 1999 survey sets out the baseline. It is a dynamic general equilibrium model with money and temporary nominal price rigidities. The behavioural equations are derived from optimisation by households and firms rather than written down directly, which is the methodological inheritance from the previous lesson.

Two consequences follow immediately. Current behaviour depends on expectations of the future course of policy as well as on policy today, because an optimising household or firm is planning over time. And in the limiting case where prices are perfectly flexible, the model's dynamics resemble a real business cycle model with monetary policy affecting only nominal variables.

The output gap in this framework is defined against the level of output that would arise if wages and prices were perfectly flexible, which is a theoretical construct rather than an observed series. That definition matters for everything policy does with it.

Why the rigidities do the work

If every price adjusted instantly, a change in the nominal interest rate would change nothing real. Prices that move slowly mean that a change in the nominal rate is, for a while, a change in the real rate, and real rates change spending decisions.

That is the entire mechanism by which monetary policy affects output here, and it is a much narrower channel than the one the account in this track uses. The composition of investment across time is not represented; the survey's baseline abstracts from capital accumulation entirely, and says the abstraction does not change its qualitative conclusions.

Rules, discretion and the credibility problem

The survey's central policy question is whether a central bank does better by committing to a rule or by optimising each period. Because expectations of future policy affect behaviour now, a bank that can commit changes today's outcome by changing what people expect, and a bank that cannot is stuck with the outcomes its discretion produces.

That is where policy rules of the Taylor kind enter this literature, and it is why the argument about the 2000s in the previous course is conducted in the language of deviations from a rule.

Where it sits relative to this track

The disagreement is about what is missing rather than about what is there.

This framework has money affecting real activity, which the previous lesson does not, and it is used by the institutions the track keeps referring to. What it does not have is capital structure: no stages of production, no claim that a rate below some sustainable level draws resources toward activities remote from consumption. In the baseline it does not have capital at all.

It also, as the financial cycle survey in the previous course notes, treated finance as a veil until recently, and the route back was to graft financial frictions onto this same structure rather than to rebuild it.

Check yourself