INTRODUCTION The label “New Keynesian” suggests that the new framework features a nominal rigidity that is instrumental in propagating the eﬀects of shocks to the economy. Because of the existence of this nominal rigidity, a change in the stance of monetary policy, too, leads to predictable changes in real output. But traditional Keynesian models and the New Keynesian framework diﬀer on the exact nature of this nominal rigidity. Earlier Keynesian models emphasized the existence of sticky wage rates. New Keynesian models take a much more eclectic view of the sources of nominal rigidities in the economy. We begin here by considering New Keynesian models that feature sticky prices. These New Keynesian models assume that ﬁrms operate in a monopolistically competitive setting; they are price setters. In this environment ﬁrms ﬁnd it costly to adjust prices because of the existence of menu cost or out of fear of harming customer relations. Alternatively, they may lack total control over setting prices and instead face an exogenous stochastic price adjustment process. Irrespective of the particular form of the price adjustment process in the New Keynesian framework, ﬁrms take a forwardlooking perspective when setting current prices. Firms look at the future because they realize that they may be unable to change their prices for a while. Thus expected future developments inﬂuence the setting of current prices. The existence of sticky prices and the forward-looking perspective adopted by ﬁrms give rise to a dynamic path for the aggregate price level. This path...
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