The details of this paper may not interest all of you as the paper involves fairly technical issues regarding New Keynesian models and monetary policy, but the general question is straightforward. Do policymakers face an inflation-output tradeoff when conducting monetary policy? In standard versions of the New Keynesian model they do not, a situation known as divine coincidence. Greg Mankiw’s discussion of divine coincidence, an ideal situation for a policymaker, was presented here. Here’s another paper on this topic that will be presented at this conference sponsored by the Federal Reserve Board and The Journal of Money, Credit, and Banking (the link has other interesting conference papers as well) showing that divine coincidence is due to a special feature of the New Keynesian model:
"Real Wage Rigidities and the New Keynesian Model," Olivier Blanchard and Jordi Gali, September 9, 2005: Abstract Most central banks perceive a trade-off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade-off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare-relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence, is due to a special feature of the model, the absence of non trivial real imperfections. We focus on one such real imperfection, namely real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade-off between stabilizing inflation and stabilizing the welfare-relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interpretation for the dynamic inflation-unemployment relation found in the data.