In recent years, dynamic stochastic general equilibrium (DSGE) models of monetary economies have focused on the role of nominal rigidities in affecting the economy's adjustment to monetary policy and non-policy disturbances. While these rigidities appear important for understanding the impact nominal shocks have on such real variables as output and employment, models with only nominal rigidities have been unable to match the responses to monetary disturbances that have been estimated in the data. Typically, empirical studies have concluded that monetary shocks generate large and persistent real responses that display a hump shape. After a positive money shock, for example, output rises over several quarters and then declines. Christiano, Eichenbaum and Evans (1999) document this effect and provide an extensive discussion of the empirical evidence on the effects of monetary shocks. Sims (1992) finds large, hump-shaped responses of real output to monetary shocks in several OECD countries. Inflation also displays a hump-shaped response, although inflation is usually found to respond more slowly than output to monetary shocks.
The ‘stylised facts’ emphasised by Christiano, Eichenbaum and Evans, by Sims, and by others are illustrated in figure 9.1, which shows estimated impulse responses of output and inflation following a shock to the growth rate of money. These responses were obtained from a three-variable VAR (output, inflation, and money growth) estimated using US quarterly data for 1965–2001. Output is real GDP, inflation is measured by the Consumer Price Index, and M2 is the aggregate used to measure money. The real persistence and inflation inertia seen in figure 9.1 has been hard for models based on nominal rigidities to match. As Dotsey and King (2001) have expressed it, ‘modern optimizing sticky price models have displayed a chronic inability to generate large and persistent real responses to monetary shock’.
In order to capture at least some of the real persistence seen in empirical studies, models based on nominal rigidity generally must assume a high degree of price stickiness. For example, it is common to assume that individual prices remain fixed on average for as much as nine months. Micro data on individual prices, however, suggests that prices typically change more frequently than this. Consequently, a number of researchers have recently argued that simply adding nominal rigidities to an otherwise standard DSGE model is not sufficient to match the persistence observed in the data.