Optimal monetary policy and the equivalency between the one-period AD–AS model and the forward-looking New Keynesian model

Abstract

It is shown how a one-period aggregate demand–aggregate supply (AD–AS) model yields equivalent expressions for inflation and output under optimal monetary policy as a forward-looking New Keynesian model. Furthermore the advantage that the AD–AS model has over the New Keynesian specification when evaluating policy efficiency is evaluated.

Acknowledgements

The author thanks Alfonso Flores-Lagunes and Zheng Liu for useful discussion. All errors are the author's.

Notes

¹ The equilibrium value of the interest rate is defined as the value needed such that output would equal its potential (or target) level.

² A similar version of this model can be found in (Cecchetti1998). See also Krause (2003) for a theoretical derivation of the model using a rational expectations optimization process in the presence of imperfect information.

³ Note that we have redefined their original residuals u_t and g_t with s_t  = −u_t and in order to achieve an easier comparison between the outcomes of the two models. Clearly, these two normalizations do not affect the key properties of their residuals.

⁴ Equations 13 and 14 are equivalent to Equations 3.4 and 3.5 in CGG (1999).

⁵ (Cecchetti and Krause2001) use the measure given in Equation 20 to examine changes in monetary policy-maker's performance for a cross-section of 23 countries between the 1980s and the 1990s. (Eichengreen2004) employs this measure to study the reorientation of monetary policy in 11 countries after the Great Depression, by comparing performance between the periods 1919 to 1930 and 1931 to 1939.