Dynamic stochastic general equilibrium (DSGE) models to evaluate monetary policy rules anchored in rich micro-foundations have become a popular tool for macroeconomic analysis in recent years (Tovar, 2008). In this vein, we estimate a small open economy DSGE model for Jordan. These models—often refered to as New Keynesian—demonstrate the non-trivial effects of monetary policy on real variables in the presence of nominal and real rigidities. In

particular, the existence (or absence) of certain rigidities have implications for the trade-off between output and inflation stabilization that central banks face. For instance, standard new Keynesian models with nominal price rigidities and flexible wages generate a strong policy prescription: the role of monetary policy is to fully stabilize inflation. In this setup, inflation depends only on expected inflation and the gap between current output and its natural level (that is, the level that would prevail in the absence of nominal stickiness). Standard reduced-form models, with no explicit microeconomic foundations, are unable to identify, in practice, the source of nominal and real frictions. Erceg, Henderson, and Levin (2000) find two important results when both wage and price decisions are staggered (i.e., removing the assumption that wages are flexible). First, the policymaker’s welfare function depends on the variance of output, price inflation, and wage inflation; second, it becomes impossible to set more than one variance to zero in the face of exogenous shocks. They thus demonstrate that, in contrast to the standard new Keynesian model with only price rigidities, there is a trade-off between stabilizing the output gap, price inflation, and wage inflation.