The Canonical New Keynesian Monetary Policy Model:
A System Dynamics Translation
I. David Wheat! and Marianna Oleskevych?
Extended Abstract
We model a simplified version of the workhorse monetary policy model of many central banks:
the New Keynesian Monetary Policy Model (NKMP). While best known in its simple 3-equation
canonical form, the NKMP is actually used in much more complex versions adapted to the
structure of specific nations’ economies and monetary policy requirements. We add stock-and-
flow structure to the NKMP and highlight the significance of delays inherent in the stock-
adjustment processes that are largely ignored in the NK literature. We retain the simplicity of the
NKMP while improving its transparency. Our goal is more than enriching the scholarly and
pedagogical literature, as important as those tasks are. We are working with economists at the
National Bank of Ukraine (NBU) who have developed their own version of the NK monetary
policy model, and the modeling work discussed in this paper is our first step in developing a
robust SD version of the NBU model.
The way monetary policy makers think about their problems (their mental models of those
problems) has become increasingly institutionalized inside central banks in the form of simple,
small quantitative models (computer models for their laptops, or even iPads). These models are
used to promote critical thinking and provoke internal debate about systemic relationships in the
part of the macro economy of greatest concern to them--the source of inflation dynamics. In the
mid-20th century, the static IS-LM model served that purpose (poorly). Today, it is the dynamic
NKMP expounded by Clarida, Gali, and Gertler (1999) and extended by countless others over the
past two decades. The most complex version combines a neoclassical, rational expectations,
optimizing micro-foundations approach with Keynesian sticky wages and prices (e.g. Gali, 2008).
De Grauwe (2012) challenges the restrictive DSGE definition of 'rational' and employs 'bounded
rationality’ in his formulation of expectations. In this paper, we draw upon the NKMP version
extended by De Grauwe (2012) to incorporate bounded rationality’ expectations (Simon, 1997) as
an alternative to the 'rational expectations' that is more common in the NKMP literature.
The three key equations in the standard NKMP model are:
inflation ,= al *inflation ,., + (1-al)*inflation target ,.; + b1*output gap ; NKI
output gap , = a2*output gap ,.; + (1-a2)* target output gap ,,; + b2*(nominal IR , - expected inflation ,,;) NK2
nominal interest rate , = cl *inflation gap + c2*output gap , + c3*nominal interest rate ;.; NK3
Figure 1 displays the current version of our model, where the three NK equations appear
indicated inflation (NK1), target nominal interest rate (NK3), and indicated AD (NK2). Each is a
'goal' for an information stock that adjusts over time in our SD framework.’
' University of Bergen, Norway; National University of Kyiv-Mohyla Academy, Ukraine; ISM University
of Management and Economics, Lithuania.
? Ivan Franko National Unive: ‘ity of Lviv, Ukraine.
3 Our model, developed with Stella Architect (from is fems.com), is available for inspection, testing,
and conducting simulation experiments. A version that runs online is available at
https://exchange.iseesystems.com/public/david-wheat/sd-nk/index.html#page |.
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An intuitive grasp of the model can be gained with the following thought experiment. Assume
there is an exogenous shock that increases AD. That would increase desired GDP, capacity
utilization, actual GDP, income, and indicated AD, thus closing a reinforcing feedback loop that
would push AD even higher. Meanwhile, the rise in GDP without an offsetting rise in Potential
GDP (assumed constant in the short run) would create a positive output gap and eventually boost
inflation. Rising inflation would lower the real interest rate and raise indicated AD even more.
Moreover, both loops reinforce each other. From the perspective of an inflation fighter, this is a
vicious process that needs to be arrested by a counteracting policy intervention--a Taylor Rule
(Taylor 1993). In this situation, raising the nominal interest rate more than the increase in
inflation would cause the real interest rate to rise, thus counteracting the influence of the two
reinforcing loops. Policy Target & Resuts | Infation | Ouiput Gap
s
With the default parameter settings in the L/P |
model, inflation approaches a 2 per cent 1
inflation target in about two years (Figure 2),
an outcome consistent with empirical findings
(Bank of England 1999). More aggressive
settings enable reaching the inflation target
sooner, but generate instability in prices,
output, and interest rates. Timid settings fail to ol 7 + + ;
bring inflation back under control within —intaton — —palcy ate" eget aon
acceptable time horizons.
Per Year
Figure 2. Results with Default Parameter Settings
A prerequisite for SD-based monetary policy models to be taken seriously by central bank
economists is a good-faith effort to communicate with them on their terms, and an SD translation
of theories-in-use by those economists is a good place to start. Our long run goal is to
demonstrate the value added to their theories by an SD approach and suggest extensions and
modifications to their theories.
References
Bank of England (1999). The Transmission Mechanism of Monetary Policy, p. 167.
https:/Awww.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1999/the-
transmission-mechanism-of-monetary-policy
Clarida, R., Gali, J. and Gertler, M. (1999). The Science of Monetary Policy: A New
Keynesian Perspective. Journal of Economic Literature XXXVII: 1661-1707.
Gali, J. (2008). Me ry Policy, Inflation, and the Busi Cycle. Oxford: Princeton
University Press.
De Grauwe, P.D. (2012). Lectures on Behavioral Economics. Oxford: Princeton
University Press.
Forrester, J. W. (1961) Industrial Dynamics. Cambridge: MIT Press.
Forrester, JW. (1969). Urban Dynamics. Waltham, MA: Pegasus Communications.
Sterman, J.D. (2000). Business Dynamics: Systems Thinking and Modeling for a Complex
World. Boston: McGraw-Hill.
Simon, H.A. (1997). Models of Bounded Rationality: Empirically Grounded Economic
Reason, Volume 3. Cambridge USA: MIT Press.
Taylor, J.B. (1993). Discretion versus Policy Rules in Practice. Carnegie-Rochester
Conference Series on Public Policy, 39, pp. 195-214.
Wheat, LD. (2015). Model-based Policy Design that Takes Implementation Seriously, in
E.W. Johnston (ed.) Governance in the Information Era: New York: Routledge.
