The relationship between output and inflation has long been of interest in the monetary economics literature. Today, some consensus has formed about some important issues. For instance, the general view is that this relationship is at most weak in the long-run, reflecting a sort of classical dichotomy between nominal and real variables. On the other hand, the short run seems to be well described by some variant of the New Keynesian Phillips Curve (NKPC). Yet despite the emerging consensus for using the NKPC to model the short run, there remains considerable disagreement about what form it should take. Numerous studies have shown that the strictly forward looking NKPCs are unable to replicate many of the empirical patterns found in the data. However, one limitation of many of these studies is that they have focused on models consisting of just a single NKPC equation (i.e. the aggregate supply) and have overlooked the aggregate demand side of the economy and its interaction with the NKPC. This focus on single equation NKPC models often results in misleading conclusions. Less attention has been placed on more fully specified general equilibrium models.

This paper fills this gap by investigating the short run performance of the NKPC in a small-scale general equilibrium model with several sources of persistence. We use a general equilibrium structure that is rich enough so as to reproduce the key statistical features seen in the data that are not easily matched in single equation NKPC models, but also is simple enough, in contrast with the recent medium-scale models as in Smets and Wouters (2003, 2007), so that it is possible to understand exactly which model features are necessary to match the dynamic patterns of output and inflation data.