Brookings Papers on Economic Activity, 1: 988 average infation from 10 percent to 5 percent substantially alters the short run impact of aggregate demand The body of the paper consists of three major sections. The first discusses the new research that provides microeconomic foundations for Keynesian theories. The second presents a model of price adjustment It demonstrates the connection between average inflation and the slope of the Phillips curve and contrasts this result with the predictions of other theories. The third section provides both cross-country and time series evidence that supports the predictions of the model New Keynesian Theories According to Keynesian economics, fluctuations in employment and output arise largely from fluctuations in nominal aggregate demand. The reason that nominal shocks matter is that nominal wages and prices are not fully flexible. These views are the basis for conventional accounts of macroeconomic events For example, the consensus explanation for the 1982 recession is slow growth in nominal demand resulting from tight monetary policy. The research program described here is modest in the sense that it seeks to strengthen the foundations of this conventional thinking, not to provide a new theory of fluctuations, In particular, its goal is to answer the theoretical question of how nominal rigidities arise from optimizing behavior, since the absence of an answer in the 1970s was largely responsible for the decline of Keynesian economics In the following discussion we first describe the central point of the recent literature: large nominal rigidities are possible even if the frictions preventing full nominal flexibility are small. We next describe some phenomena that greatly strengthen the basic argument, including rigidi ties in real wages and prices and asynchronized timing of price changes We then discuss two innovations in recent models that are largely responsible for their success: the introduction of imperfect competition and an emphasis on price as well as wage rigidity. Finally, we argue tha the ideas in recent work are indispensable for a plausible Keynesian account of fluctuations. 5 5. Some of the ideas of this literature are discussed informally by earlier Keynesian authors. To cite just two examples, see the discussion of asynchronized timing of price changes in Robert J. Gordon, Output Fluctuations and Gradual Price Adjustment