The Extended Perturbation Method: New Insights on the New Keynesian Model

Martin Møller Andreasen, Anders Farver Kronborg

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This paper introduces the extended perturbation method, which improves upon standard perturbation by removing approximation errors under perfect foresight. For the New Keynesian model, we show that standard perturbation generates explosive sample paths because it does not account for the upper bound on inflation as implied by Calvo pricing. In contrast, extended perturbation generates stable dynamics as it enforces this bound. Extended perturbation also adds to existing evidence on downward nominal wage rigidities in the New Keynesian model, as we only find support for this friction when using standard perturbation but not when using the more accurate extended perturbation approximation.
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages43
Publication statusPublished - 27 Mar 2017
SeriesCREATES Research Paper

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