INTRODUCTION
A New Neo-classical Synthesis (NNS) is merging three traditions that have dominated macroeconomic modelling for the last thirty years. In the 1970s, Sargent andWallace (1975) and others added rational expectations to the IS-LM models that were then being used to evaluate monetary policy; somewhat later, Calvo (1983) and Taylor (1980) introduced richer dynamic specifications for the nominal rigidities that were assumed in some of those models. In the 1980s, Kydland and Prescott (1982) and others introduced the Real Business Cycle (RBC) model, which sought to explain business cycle regularities in a framework with maximising agents, perfect competition, and complete wage/price flexibility.
The NNS reintroduces nominal rigidities and the demand determination of employment and output. Monopolistically competitive wageand price-setters replace the RBC model's perfectly competitive wage- and price-takers; monopoly markups provide the rationale for suppliers to expand in response to an increase in demand; and the Dixit and Stiglitz (1977) framework – when combined with complete sharing of consumption risks – allows the high degree of aggregation that has been a hallmark of macroeconomic modelling.
In this chapter, we present a simple model that can be used to illustrate elements of the NNS and recent developments in the macroeconomic stabilisation literature. We do not attempt to survey this rapidly growing literature. Instead, we focus on a set of papers that are key to a question that is currently being hotly debated: is price stability a good strategy for macroeconomic stabilisation? If so, some of the generally accepted tradeoffs in modern central banking would seem to evaporate. For example, inflation (or price-level) targeting need not be seen as a choice that excludes Keynesian stabilisation, and it would be unnecessary to give price stability such primacy in the statutes of the new central bank in Europe.
In section 2, we present our model and discuss some fundamental characteristics of the NNS. Our model is simpler than that which appears in much of the literature because we have replaced the dynamic Calvo and Taylor specifications of nominal rigidity with the assumption that some wages and/or prices are set one period in advance. This allows us to derive closed form equilibrium solutions for a class of utility functions and assumptions about the distribution of macroeconomic shocks.