Demand shocks, new keynesian model and supply effects of monetary policy

Demand shocks likely play a key role in driving business cycles. However, in the standard newkeynesian model, the monetary policy reaction to these shocks have a supply side effect. Thechange in real rate affects the marginal utility of consumption generating an income effect onlabor supply. Wages, inflation and through monetary policy, aggregate demand will increase.This supply side effect have a surprising importance for the model, especially when the sensi-tivity of aggregate demand to interest rate is low. A demand shock will have a large impact(close to one) on output, but a very small one on the output gap. The limited monetary policymovement induced by the taylor rule remains very close to the natural rate of interest. Thereare nearly no differences between the sticky price and the flexible price model. It representsa very disappointing result, the entire purpose of sticky prices being to generate inefficiencieswhen the aggregate demand is hit. Coupled with very tiny empirical support for this supplyside effect of monetary policy, it suggests to explore the theoretical possibilities to kill this ef-fect. First, we review the two ways the literature have proposed, nonseparable preferences andsticky wages. The main drawback is a strong reliance on very specific assumption for the labormarket. We explore an alternative approach. We attempt a radical departure from traditionnalassumption about the optimizing behavior of the representative agent. Instead of optimizingsimulatneously with respect to hours, consumption and saving, the household decomposes theproblem in two steps. First, the agent chooses between labor income and hours. Second, heoptimizes between consumption and saving. The interest is to disentangle the income effectwhich affects the labor equation and those affecting the intertemporal choice. Thus it is possibleto reduce the wealth effect on labor supply whereas keeping a low sensitivity of consumptionto interest rate. This flexible approach also allows to challenge the effect of interest rate onwealth offering a potential explanation for small effects of interest rate on both labor supplyand consumption whereas keeping large income effects