The Effects of Monetary Policy in a Multi-Sector New Keynesian Model: An Analysis Using Recent Micro Evidence on Price Changes

Master Thesis by Aysegül Sanli
August 9, 2005

Abstract:

Economic modelling generally assumes one-sector to represent the whole economy, whereas real economies consist of many sectors with varying price durations. We try to model this variety by setting up a multi-sector New Keynesian model based on the model outlined in Gali (2002). The Calvo parameter estimates of our model are calculated using the data set provided by Bils and Klenow (2004). We group similar price durations as sectors and form ten sectors to represent the whole economy. Our first aim is to study the responses of the multi-sector economy to policy shocks. The outcomes show that aggregate price, interest and output display interesting dynamics under such a setting. Then we try to match the responses of the multi-sector economy with one-sector models. We find that for our baseline model, the aggregate responses of the multi-sector economy can be well mimicked by a one-sector model with a price duration of around 2.9 months. This model is able to duplicate the aggregate responses, whereas the variety in the dynamics of responses can only be captured with at least two sector-models. We test our results under different parametrization. The proposed price duration for one-sector model is still able to match the aggregate impulse responses well but we see that it is not very precise in matching the volatility of the multi-sector model. Under similar settings, the two-sector performs better. Next, we change the labor assumptions of the baseline model and assume specific factor markets. The results show that prices and inflation response by little to policy shocks now. The new impulse responses are well matched with one- and two-sector models with the proposed price durations. Whereas in terms of matching the volatility, onesector estimate performs poorly and the new price duration increases to around 4 months. However, this value lacks the precision of the previously proposed price duration in matching the aggregate response levels.