The case for price stability with a flexible exchange rate in the New Neoclassical Synthesis.

• Author: Goodfriend, Marvin
• Position: Report

The New Neoclassical Synthesis is a natural starting point for the consideration of welfare-maximizing monetary arrangements in the international context. Alternatively known as the New Keynesian model, this consensus model of monetary policy deserves our attention because it embodies cumulative advances in theory and policy informed by decades of monetary experience from around the world. The consensus model with its prescription for price stability serves today as the foundation for thinking about monetary policy at central banks and universities worldwide. (1)

The purpose of the article is to review the fundamental principles of monetary policy in terms of the New Synthesis. The first section describes briefly the structure of the baseline NNS model. The second section presents the ease for price stability in the NNS model. The third section extends the discussion to the open economy and presents the NNS case for a flexible exchange rate. The fourth section tells why monetary policy is fragile that simultaneously attempts to fix the foreign exchange rate and pursue interest rate policy to sustain price stability.

The New Neoclassical Synthesis

The convergence of thinking embodied in the modern consensus model of monetary policy is reflected in the fact that it goes by two names--the New Neoclassical Synthesis and the New Keynesian model. The NNS framework inherits intertemporal optimization, rational expectations, and a real business cycle (RBC) core from the classical side, and monopolistic competition, nominal price rigidities, and a prominent role for monetary stabilization policy from the Keynesian side. Both classical and Keynesian contributions are compatible in the NNS framework because of its microeconomic foundations.

The baseline NNS model is built up from household intertemporal utility maximization and firm profit maximization. (2) In the NNS model, representative households maximize utility by choosing life-time consumption, and how much work effort to supply each period to firms which produce the consumption goods.

Monopolistically competitive firms produce differentiated consumption goods, exercise market power, and maximize profits by pricing their differentiated products at a markup over marginal production costs. Firms are owned by households, which earn both wage and profit income. Households have access to a credit market where they can borrow or lend. Households take product prices, the red wage in the labor market, and the real interest rate in the credit market as given in making their choices. Firms take wages as given when choosing how much work effort to hire in the labor market.

A firm incurs decision costs to determine the relative price that maximizes its profits. Pricing decisions must be overseen by management. Pressing problems compete for scarce management time. Hence, pricing gets management's attention on a stochastic basis depending on its perceived urgency relative to other pressing concerns.

The NNS model puts the markup at the core of the pricing decision. According to the model, a firm considers changing its nominal product price only when demand or cost conditions are expected to move its actual markup significantly and persistently away from its flexible-price profit-maximizing markup. For instance, a firm would raise its nominal product price if higher nominal wage growth or...