Stochastic equilibrium, the Phillips curve and Keynesian economics
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Abstract
I uncover serious problems with the benchmark New Keynesian Phillips curve linearized
around its non-stochastic zero inflation steady state when the underlying
model features a subset of prices that stay rigid over multiple periods, as in the
popular Calvo model. I am able to demonstrate that the dynamics of approximations
taken at the non-stochastic steady state are non-hyperbolic. This means that
approximations taken at this point do not represent a valid description of the dynamics
of the underlying model at any other point in the state space. This allows
me to overturn results such as the ’Divine Coincidence’ that equates welfare under
price rigidity with the level prevailing under price dispersion. I introduce a dynamic
stochastic concept of equilibrium that can be applied to New Keynesian models and
offers a natural point to take approximations to analyze business cycle dynamics. It
is methodologically interesting as it is a notion of general equilibrium that does not
correspond to partial equilibrium.
Keywords: Macroeconomics, Mathematical Economics, Random Dynamical Systems,
General Equilibrium, Monetary Policy
JEL Classification: C6, D5, E1, E3, E5
2010 Mathematics Subject Classification: 37Axx, 37Bxx, 37Cxx, 37Dxx,
37Gxx, 37Hxx