I need to calculate potential output in a New Keynesian DSGE model. For that, I specify the flexible price economy of the model by setting the Calvo price reset probability to 1.
How should I close this flexible price economy? With flexible prices, monetary policy is ineffective. So, I can’t specify a central bank’s reaction function. But I still need to specify a rule for either the interest rate or inflation to close the model. In Smets and Wouters (2003), the inflation is set to 1 every period which implies full inflation stabilization all times. Is this the only way? Any thoughts will be appreciated.