《货币银行学》课程教学资源（参考文献）Gali-Macroeconomic Modeling for Monetary Policy Evaluation

NBER WORKING PAPER SERIES MACROECONOMIC MODELING FOR MONETARY POLICY EVALUATION Jordi Gali Mark Gertler Working Paper 13542 http://www.nber.org/papers/w13542 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge,MA 02138 October 2007 The authors thank Jim Hines,Andrei Shleifer,Jeremy Stein,and Timothy Taylor for helpful comments and suggestions on an earlier draft,and Steve Nicklas for excellent research assistance.Gali is grateful to CREA-Barcelona Economics and Ministerio de Educacion y Ciencia.Gertler thanks the NSF and the Guggenheim Foundation.The views expressed herein are those of the author(s)and do not necessarily reflect the views of the National Bureau of Economic Research. 2007 by Jordi Gali and Mark Gertler.All rights reserved.Short sections of text,not to exceed two paragraphs,may be quoted without explicit permission provided that full credit,including notice, is given to the source

NBER WORKING PAPER SERIES MACROECONOMIC MODELING FOR MONETARY POLICY EVALUATION Jordi Galí Mark Gertler Working Paper 13542 http://www.nber.org/papers/w13542 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 October 2007 The authors thank Jim Hines, Andrei Shleifer, Jeremy Stein, and Timothy Taylor for helpful comments and suggestions on an earlier draft, and Steve Nicklas for excellent research assistance. Galí is grateful to CREA-Barcelona Economics and Ministerio de Educación y Ciencia. Gertler thanks the NSF and the Guggenheim Foundation. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. © 2007 by Jordi Galí and Mark Gertler. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source

Macroeconomic Modeling for Monetary Policy Evaluation Jordi Gali and Mark Gertler NBER Working Paper No.13542 October 2007 JEL No.E31.E32,E52 ABSTRACT We describe some of the main features of the recent vintage macroeconomic models used for monetary policy evaluation.We point to some of the key differences with respect to the earlier generation of macro models,and highlight the insights for policy that these new frameworks have to offer.Our discussion emphasizes two key aspects of the new models:the significant role of expectations of future policy actions in the monetary transmission mechanism,and the importance for the central bank of tracking of the flexible price equilibrium values of the natural levels of output and the real interest rate.We argue that both features have important implications for the conduct of monetary policy. Jordi Gali Centre de Recerca en Economia Internacional(CREI) Ramon Trias Fargas 25 08005 Barcelona SPAIN and NBER jordi.gali@upf.edu Mark Gertler Department of Economics New York University 269 Mercer Street,7th Floor New York,NY 10003 and NBER mark.gertler@nyu.edu

Macroeconomic Modeling for Monetary Policy Evaluation Jordi Galí and Mark Gertler NBER Working Paper No. 13542 October 2007 JEL No. E31,E32,E52 ABSTRACT We describe some of the main features of the recent vintage macroeconomic models used for monetary policy evaluation. We point to some of the key differences with respect to the earlier generation of macro models, and highlight the insights for policy that these new frameworks have to offer. Our discussion emphasizes two key aspects of the new models: the significant role of expectations of future policy actions in the monetary transmission mechanism, and the importance for the central bank of tracking of the flexible price equilibrium values of the natural levels of output and the real interest rate. We argue that both features have important implications for the conduct of monetary policy. Jordi Galí Centre de Recerca en Economia Internacional (CREI) Ramon Trias Fargas 25 08005 Barcelona SPAIN and NBER jordi.gali@upf.edu Mark Gertler Department of Economics New York University 269 Mercer Street, 7th Floor New York, NY 10003 and NBER mark.gertler@nyu.edu

Quantitative macroeconomic modeling fell out of favor during the 1970s for two related reasons.First,some of the existing models,like the Wharton Econometric model and the Brookings Model,failed spectacularly to fore- cast the stagflation of the 1970s..Second,leading macroeconomists leveled harsh criticisms of these frameworks.Lucas (1976),and Sargent (1981),for example,argued that the absence of an optimization-based approach to the development of the structural equations meant that the estimated model co- efficients were likely not invariant to shifts in policy regimes or other types of structural changes.Similarly,Sims (1980)argued that the absence of convincing identifying assumptions to sort out the vast simultaneity among macroeconomic variables meant that one could have little confidence that the parameter estimates would be stable across different regimes.These power- ful critiques made clear why econometric models fit largely on statistical relationships from a previous era did not survive the structural changes of 1970s. In the 1980s and 1990s,many central banks continued to use reduced form statistical models to produce forecasts of the economy that presumed no structural change,but they did so knowing that these models could not be used with any degree of confidence to generate forecasts of the results of policy changes.Thus,monetary policy-makers turned to a combination of instinct,judgment,and raw hunches to assess the implications of different policy paths for the economy. Within the last decade,however,quantitative macroeconomic frameworks for monetary policy evaluation have made a comeback.What facilitated the development of these frameworks were two independent literatures that 1

Quantitative macroeconomic modeling fell out of favor during the 1970s for two related reasons. First, some of the existing models, like the Wharton Econometric model and the Brookings Model, failed spectacularly to fore￾cast the stagáation of the 1970s..Second, leading macroeconomists leveled harsh criticisms of these frameworks. Lucas (1976), and Sargent (1981), for example, argued that the absence of an optimization-based approach to the development of the structural equations meant that the estimated model co￾e¢ cients were likely not invariant to shifts in policy regimes or other types of structural changes. Similarly, Sims (1980) argued that the absence of convincing identifying assumptions to sort out the vast simultaneity among macroeconomic variables meant that one could have little conÖdence that the parameter estimates would be stable across di§erent regimes. These power￾ful critiques made clear why econometric models Öt largely on statistical relationships from a previous era did not survive the structural changes of 1970s. In the 1980s and 1990s, many central banks continued to use reduced form statistical models to produce forecasts of the economy that presumed no structural change, but they did so knowing that these models could not be used with any degree of conÖdence to generate forecasts of the results of policy changes. Thus, monetary policy-makers turned to a combination of instinct, judgment, and raw hunches to assess the implications of di§erent policy paths for the economy. Within the last decade, however, quantitative macroeconomic frameworks for monetary policy evaluation have made a comeback. What facilitated the development of these frameworks were two independent literatures that 1

emerged in response to the downfall of traditional macroeconomic modelling: New Keynesian theory and real business cycle theory.1 The New Keynesian paradigm arose in the 1980s as an attempt to provide microfoundations for key Keynesian concepts such as the inefficiency of aggregate fluctuations, nominal price stickiness,and the non-neutrality of money (e.g.Mankiw and Romer (1991)).The models of this literature,however,were typically sta- tic and designed mainly for qualitative as opposed to quantitative analysis. By contrast,real business cycle theory,which was developing concurrently, demonstrated how it was possible to build quantitative macroeconomic mod- els exclusively from the "bottom up"-that is,from explicit optimizing be- havior at the individual level (e.g.Prescott (1986))These models,however, abstracted from monetary and financial factors and thus could not address the issues that we just described.In this context,the new frameworks reflect a natural synthesis of the New Keynesian and real business cycle approaches. Overall,the progress has been remarkable.A decade ago it would have been unimaginable that a tightly structured macroeconometric model would have much hope of capturing real world data,let alone of being of any use in the monetary policy process.However,frameworks have been recently devel- oped that forecast as well as the reduced form models of an earlier era (for example,Christiano,Eichenbaum,and Evans (2005),Smets and Wouters (2003,2006)).Because these models have explicit theoretical foundations, they can also be used for counterfactual policy experiments.A tell-tale sign that these frameworks have crossed a critical threshold for credibility is their widespread use at central banks across the globe.While these models are 1For references to NK theory see,Mankiw and Romer(1991).For references to RBC theory,see Prescott (1986). 2

emerged in response to the downfall of traditional macroeconomic modelling: New Keynesian theory and real business cycle theory.1 The New Keynesian paradigm arose in the 1980s as an attempt to provide microfoundations for key Keynesian concepts such as the ine¢ ciency of aggregate áuctuations, nominal price stickiness, and the non-neutrality of money (e.g. Mankiw and Romer (1991)). The models of this literature, however, were typically sta￾tic and designed mainly for qualitative as opposed to quantitative analysis. By contrast, real business cycle theory, which was developing concurrently, demonstrated how it was possible to build quantitative macroeconomic mod￾els exclusively from the îbottom upîñ that is, from explicit optimizing be￾havior at the individual level (e.g. Prescott (1986)) These models, however, abstracted from monetary and Önancial factors and thus could not address the issues that we just described. In this context, the new frameworks reáect a natural synthesis of the New Keynesian and real business cycle approaches. Overall, the progress has been remarkable. A decade ago it would have been unimaginable that a tightly structured macroeconometric model would have much hope of capturing real world data, let alone of being of any use in the monetary policy process. However, frameworks have been recently devel￾oped that forecast as well as the reduced form models of an earlier era (for example, Christiano, Eichenbaum, and Evans (2005), Smets and Wouters (2003, 2006)). Because these models have explicit theoretical foundations, they can also be used for counterfactual policy experiments. A tell-tale sign that these frameworks have crossed a critical threshold for credibility is their widespread use at central banks across the globe. While these models are 1For references to NK theory see, Mankiw and Romer (1991). For references to RBC theory, see Prescott (1986). 2

nowhere close to removing the informal dimension of the monetary policy process,they are injecting an increased discipline to thinking and communi- cation about monetary policy. To be sure,there were some important developments in between the tra- ditional macroeconometric models and the most recent vintage.Frameworks such as Taylor(1979)and Fuhrer and Moore(1995)incorporated several im- portant features that were missing from the earlier vintage of models:(i)the Phelps/Friedman natural rate hypothesis of no long-run tradeoff between in- flation and unemployment,and(ii)rational formation of expectations.At the same time,however,the structural relations of these models typically did not evolve from individual optimization.The net effect was to make these frame- works susceptible to some of the same criticisms that led to the demise of the earlier generation of models(see,e.g.Sargent,1981).It is also relevant that over the last twenty years there have been significant advances in dynamic optimization and dynamic general equilibrium theory.To communicate with the profession at large,particularly the younger generations of scholars,it was perhaps ultimately necessary to develop applied macroeconomic models using the same tools and techniques that have become standard in modern economic analysis. Overall,our goal in this paper is to describe the main elements of this new vintage of macroeconomic models.Among other things,we describe the key differences with respect to the earlier generation of macro models.In doing so,we highlight the insights for policy that these new frameworks have to offer.In particular,we will emphasize two key implications of these new frameworks. 3

nowhere close to removing the informal dimension of the monetary policy process, they are injecting an increased discipline to thinking and communi￾cation about monetary policy. To be sure, there were some important developments in between the tra￾ditional macroeconometric models and the most recent vintage. Frameworks such as Taylor (1979) and Fuhrer and Moore (1995) incorporated several im￾portant features that were missing from the earlier vintage of models: (i) the Phelps/Friedman natural rate hypothesis of no long-run tradeo§ between in- áation and unemployment, and (ii) rational formation of expectations. At the same time, however, the structural relations of these models typically did not evolve from individual optimization. The net e§ect was to make these frame￾works susceptible to some of the same criticisms that led to the demise of the earlier generation of models (see, e.g. Sargent, 1981). It is also relevant that over the last twenty years there have been signiÖcant advances in dynamic optimization and dynamic general equilibrium theory. To communicate with the profession at large, particularly the younger generations of scholars, it was perhaps ultimately necessary to develop applied macroeconomic models using the same tools and techniques that have become standard in modern economic analysis. Overall, our goal in this paper is to describe the main elements of this new vintage of macroeconomic models. Among other things, we describe the key di§erences with respect to the earlier generation of macro models. In doing so, we highlight the insights for policy that these new frameworks have to o§er. In particular, we will emphasize two key implications of these new frameworks. 3

1.Monetary transmission depends critically on private sector expecta- tions of the future path of the central bank's policy instrument,the short term interest rate.Ever since the rational expectations revolution,it has been well understood that the effects of monetary policy depend on private sector expectations.This early literature,however,typically studied how ex- pectations formation influenced the effect of a contemporaneous shift in the money supply on real versus nominal variables.2 In this regard,the new liter- ature differs in two important ways.First,as we discuss below,it recognizes that central banks typically employ a short term interest rate as the policy instrument.Second,within the model,expectations of the future perfor- mance of the economy enter the structural equations,since these aggregate relations are built on forward looking decisions by individual households and firms.As a consequence,the current values of aggregate output and infla- tion depend not only on the central bank's current choice of the short term interest rate,but also on the anticipated future path of this instrument.The practical implication is that how well the central bank is able to manage private sector expectations about its future policy settings has important consequences for its overall effectiveness.Put differently,in these paradigms the policy process is as much,if not more,about communicating the future intentions of policy in a transparent way,as it is about choosing the current policy instrument.In this respect,these models provide a clear rationale for the movement toward greater transparency in intentions that central banks around the globe appear to be pursuing 2.The natural (flerible price equilibrium)values of both output and the 2See.e.g.Fischer(1977)and Taylor (1980)

1. Monetary transmission depends critically on private sector expecta￾tions of the future path of the central bankís policy instrument, the short term interest rate. Ever since the rational expectations revolution, it has been well understood that the e§ects of monetary policy depend on private sector expectations. This early literature, however, typically studied how ex￾pectations formation ináuenced the e§ect of a contemporaneous shift in the money supply on real versus nominal variables.2 In this regard, the new liter￾ature di§ers in two important ways. First, as we discuss below, it recognizes that central banks typically employ a short term interest rate as the policy instrument. Second, within the model, expectations of the future perfor￾mance of the economy enter the structural equations, since these aggregate relations are built on forward looking decisions by individual households and Örms. As a consequence, the current values of aggregate output and ináa￾tion depend not only on the central bankís current choice of the short term interest rate, but also on the anticipated future path of this instrument. The practical implication is that how well the central bank is able to manage private sector expectations about its future policy settings has important consequences for its overall e§ectiveness. Put di§erently, in these paradigms the policy process is as much, if not more, about communicating the future intentions of policy in a transparent way, as it is about choosing the current policy instrument. In this respect, these models provide a clear rationale for the movement toward greater transparency in intentions that central banks around the globe appear to be pursuing. 2. The natural (áexible price equilibrium) values of both output and the 2See. e.g. Fischer (1977) and Taylor (1980) 4

real interest rate provide important reference points for monetary policy-and may fluctuate considerably.While nominal rigidities are introduced in these new models in a more rigorous manner than was done previously,it remains true that one can define natural values for output and the real interest rate that would arise in equilibrium if these frictions were absent.These nat- ural values provide important benchmarks,in part because they reflect the (constrained)efficient level of economic activity and also in part because monetary policy cannot create persistent departures from the natural values without inducing either inflationary or defationary pressures.Within tra- ditional frameworks,the natural levels of output and the real interest are typically modeled as smoothed trends.Within the new frameworks they are modelled explicitly.Indeed,roughly speaking,they correspond to the values of output and the real interest rate that a frictionless real business cycle model would generate,given the assumed preferences and technology. As real business cycle theory suggests,further,these natural levels can vary considerably,given that the economy is continually buffeted by "real"shocks including oil price shocks,shifts in the pace of technological change,tax changes,and so on.Thus,these new models identify tracking the natural equilibrium of the economy,which is not directly observable,as an important challenge for central banks. In the next section,we lay out a canonical baseline model that captures the key features of the new macro models and we draw out the correspond- ing insights for monetary policy.We then discuss some of the policy issues brought by the new models.We conclude by discussing some modifications of the baseline model that are necessary to take it to data,as well as other 5

real interest rate provide important reference points for monetary policyñand may áuctuate considerably. While nominal rigidities are introduced in these new models in a more rigorous manner than was done previously, it remains true that one can deÖne natural values for output and the real interest rate that would arise in equilibrium if these frictions were absent. These nat￾ural values provide important benchmarks, in part because they reáect the (constrained) e¢ cient level of economic activity and also in part because monetary policy cannot create persistent departures from the natural values without inducing either ináationary or deáationary pressures. Within tra￾ditional frameworks, the natural levels of output and the real interest are typically modeled as smoothed trends. Within the new frameworks they are modelled explicitly. Indeed, roughly speaking, they correspond to the values of output and the real interest rate that a frictionless real business cycle model would generate, given the assumed preferences and technology. As real business cycle theory suggests, further, these natural levels can vary considerably, given that the economy is continually bu§eted by "real" shocks including oil price shocks, shifts in the pace of technological change, tax changes, and so on. Thus, these new models identify tracking the natural equilibrium of the economy, which is not directly observable, as an important challenge for central banks. In the next section, we lay out a canonical baseline model that captures the key features of the new macro models and we draw out the correspond￾ing insights for monetary policy. We then discuss some of the policy issues brought by the new models. We conclude by discussing some modiÖcations of the baseline model that are necessary to take it to data, as well as other 5

extensions designed to improve its realism. 1 A Baseline Model In this section we lay out a baseline framework that captures the key features of the new vintage macro models and is useful for qualitative analysis.The specific framework we develop is a variant of the canonical model discussed in Goodfriend and King (1997),Clarida,Gali and Gertler(1999),Woodford (2003),and Gali (2007),among others,but modified to allow for investment.3 As with the real business cycle paradigm,the starting point is a stochas- tic dynamic general equilibrium model.More specifically,it is a stochastic version of the conventional neoclassical growth model,modified to allow for variable labor supply.4 As we suggested above,in order to make the frame- work suitable for monetary policy analysis,it is necessary not only to intro- duce nominal variables explicitly,but also some form of nominal stickiness. In this regard,three key ingredients that are the prominent features of the New Keynesian paradigm are added to the frictionless real business cycle model:money,monopolistic competition and nominal rigidities.We briefly discuss each in turn: The key role of money emphasized in the new monetary models is its 3We have avoided a label for the new frameworks because a variety have been used. Goodfriend and King employ the term "New Neoclassical Synthesis,"while Woodford uses "NeoWicksellian.At the insistence of a referee.Clarida.Gali and Gertler used "New Keynesian."The latter term has probably become the most popular,though it does not adequately reflect the influence of real business cycle theory. 4We note that the real business cycle model treats shocks to total factor productivity as the main driving force of business cycles.By contrast,estimated versions of the new mon- etary models suggest that intertemportal disturbances(i.e.,shocks to either consumption or investment spending)are key.See,e.g.Gali and Rabanal(2005),Smets and Wouters (2006)or Primiceri,Schaumberg and Tambalotti (2006). 6

extensions designed to improve its realism. 1 A Baseline Model In this section we lay out a baseline framework that captures the key features of the new vintage macro models and is useful for qualitative analysis. The speciÖc framework we develop is a variant of the canonical model discussed in Goodfriend and King (1997), Clarida, Gali and Gertler (1999), Woodford (2003), and GalÌ (2007), among others, but modiÖed to allow for investment.3 As with the real business cycle paradigm, the starting point is a stochas￾tic dynamic general equilibrium model. More speciÖcally, it is a stochastic version of the conventional neoclassical growth model, modiÖed to allow for variable labor supply.4 As we suggested above, in order to make the frame￾work suitable for monetary policy analysis, it is necessary not only to intro￾duce nominal variables explicitly, but also some form of nominal stickiness. In this regard, three key ingredients that are the prominent features of the New Keynesian paradigm are added to the frictionless real business cycle model: money, monopolistic competition and nominal rigidities. We brieáy discuss each in turn: The key role of money emphasized in the new monetary models is its 3We have avoided a label for the new frameworks because a variety have been used. Goodfriend and King employ the term "New Neoclassical Synthesis," while Woodford uses "NeoWicksellian." At the insistence of a referee, Clarida, Gali and Gertler used "New Keynesian." The latter term has probably become the most popular, though it does not adequately reáect the ináuence of real business cycle theory. 4We note that the real business cycle model treats shocks to total factor productivity as the main driving force of business cycles. By contrast, estimated versions of the new mon￾etary models suggest that intertemportal disturbances (i.e., shocks to either consumption or investment spending) are key. See, e.g. GalÌ and Rabanal (2005), Smets and Wouters (2006) or Primiceri, Schaumberg and Tambalotti (2006). 6

function as a unit of account,i.e.as the unit in which the prices of goods and assets are quoted.The existence of money thus gives rise to nominal prices.It is important,however,to distinguish between money and monetary policy:Monetary policy affects real activity in the short run purely through its impact on market interest rates.In particular,the central bank affects aggregate spending by controlling the short term interest rate and,through market expectations of its future short rate decisions,by influencing the full yield curve.To control the short term interest rate,the central bank adjusts the money supply to accommodate the demand for money at the desired interest rate.These movements in the money supply,however,exert no independent effect on aggregate demand.Because real money balances are a negligible component of total wealth,the models are designed in a way that abstracts from wealth effects of money on spending.Thus,while monetary policy is central in these models,money per se plays no role other than to provide a unit of account. In order to introduce price stickiness in a rigorous way,it is necessary that firms be price-setters as opposed to price-takers.For this reason,it is necessary to introduce some form of imperfect competition,where firms face downward sloping demand curves and,thus,a meaningful price-setting decision.A version of the Dixit-Stiglitz(1977)model of monopolistic compe- tition in which each firm produces a differentiated good and sets the price for the latter while taking as given all aggregate variables provides a simple way to accomplish this and has generally been adopted by the new frameworks. As with traditional models,what ultimately permits monetary policy to have leverage over the real economy in the short run is the existence 7

function as a unit of account, i.e. as the unit in which the prices of goods and assets are quoted. The existence of money thus gives rise to nominal prices. It is important, however, to distinguish between money and monetary policy: Monetary policy a§ects real activity in the short run purely through its impact on market interest rates. In particular, the central bank a§ects aggregate spending by controlling the short term interest rate and, through market expectations of its future short rate decisions, by ináuencing the full yield curve. To control the short term interest rate, the central bank adjusts the money supply to accommodate the demand for money at the desired interest rate. These movements in the money supply, however, exert no independent e§ect on aggregate demand. Because real money balances are a negligible component of total wealth, the models are designed in a way that abstracts from wealth e§ects of money on spending. Thus, while monetary policy is central in these models, money per se plays no role other than to provide a unit of account. In order to introduce price stickiness in a rigorous way, it is necessary that Örms be price-setters as opposed to price-takers. For this reason, it is necessary to introduce some form of imperfect competition, where Örms face downward sloping demand curves and, thus, a meaningful price-setting decision. A version of the Dixit-Stiglitz (1977) model of monopolistic compe￾tition in which each Örm produces a di§erentiated good and sets the price for the latter while taking as given all aggregate variables provides a simple way to accomplish this and has generally been adopted by the new frameworks. As with traditional models, what ultimately permits monetary policy to have leverage over the real economy in the short run is the existence 7

of temporary nominal rigidities.Because nominal prices adjust sluggishly, by directly manipulating nominal interest rates,the central bank is able to influence real rates and hence real spending decisions,at least in the short run.The traditional models introduce sluggish price adjustment by postulating a "Phillips curve"relating inflation to some measure of excess demand,as well as lags of past inflation.By contrast,these new vintage models derive an inflation equation-often referred to as the New Keynesian Phillips curve-explicitly from individual firms'price setting behavior,as we describe below. We now turn to a description of our canonical framework.As with the tra- ditional framework,it is convenient to organize the system into three blocks: aggregate demand,aggregate supply,and policy.Further,it is possible to represent each sub-sector by a single equation.In an appendix available with the online version of this paper(at http://www.e-jep.org),we build up the aggregate demand and aggregate supply relationships in detail.In what fol- lows,we present the condensed aggregate demand and supply equations along with an informal motivation.By adding an additional relation that describes monetary policy,it is then possible to express the model as a simple three equation system,similar in spirit to the way traditional models have been represented.The main difference with the traditional framework,of course, is that the new vintage of models are built on explicit micro foundations. 8

of temporary nominal rigidities. Because nominal prices adjust sluggishly, by directly manipulating nominal interest rates, the central bank is able to ináuence real rates and hence real spending decisions, at least in the short run. The traditional models introduce sluggish price adjustment by postulating a ìPhillips curveî relating ináation to some measure of excess demand, as well as lags of past ináation. By contrast, these new vintage models derive an ináation equationñoften referred to as the New Keynesian Phillips curveñexplicitly from individual Örmsíprice setting behavior, as we describe below. We now turn to a description of our canonical framework. As with the tra￾ditional framework, it is convenient to organize the system into three blocks: aggregate demand, aggregate supply, and policy. Further, it is possible to represent each sub-sector by a single equation. In an appendix available with the online version of this paper (at http://www.e-jep.org), we build up the aggregate demand and aggregate supply relationships in detail. In what fol￾lows, we present the condensed aggregate demand and supply equations along with an informal motivation. By adding an additional relation that describes monetary policy, it is then possible to express the model as a simple three equation system, similar in spirit to the way traditional models have been represented. The main di§erence with the traditional framework, of course, is that the new vintage of models are built on explicit micro foundations. 8