Excerpt from The New Keynesian Microfoundations
This paper surveys some recent efforts at deriving the standard Keynesian effects of money on output from models in which individual agents maximize their welfare. While other models with continua of equilibria are considered, most attention is spent on model with costs of changing prices. Models of the latter type also turn out to have multiple equilibria because, when a firm increases its price, its creates an incentive for its competitors to raise their own. These multiplicities are discussed in both two period and infinite horizon models. The multiplicities affect both the qualitative features of the equilibria and their welfare properties. I also analyze the extent to which small costs of changing prices can generate large (or costly from a welfare viewpoint) business cycles. Aggregate data and data on individual prices is used to discuss the empirical strengths and weaknesses of existing models.
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