As in the traditional models,the framework can incorporate exogenous fluctuations in government purchases or other aggregate demand compo- nents.These fluctuations influence both the natural level of output and the natural real interest rate.However,the form of the aggregate demand equation is not affected,since this relation is expressed in terms of gap vari- ables. Finally,we note that the compact form of the aggregate demand curve depends on the assumption of perfect capital markets,so that both the per- manent income hypothesis for consumption and the g theory for investment are valid.As we discuss later,recent work relaxes the assumption of perfect capital markets. Aggregate Supply:The aggregate supply relation evolves from the price setting decisions of individual firms.To capture nominal price inertia, it is assumed that firms set prices on a staggered basis:each period a subset of firms set their respective prices for multiple periods.Under the most common formulation,due to Calvo (1983),each period a firm adjust its price with a fixed probability that is independent of history.This assumption is not an unreasonable approximation of the evidence(Nakamura and Steinsson (2007)and Alvarez (2007)). Under flexible prices,during each period firms set price equal to a constant markup over nominal marginal cost.With staggered price setting,firms that are able to adjust in a given period set price equal to a weighted average 6The idea of using staggering to introduce nominal inertia is due to Fischer(1997) and Taylor(1980),who used it to describe nominal wage setting.A virtue of the Calvo formulation is that is facilitates aggregation.Because the adjustment probability is inde- pendent of how long a firm has kept its price fixed,it is not necessary to keep track of when different cohorts of firms adjusted their prices. 12As in the traditional models, the framework can incorporate exogenous áuctuations in government purchases or other aggregate demand compo￾nents. These áuctuations ináuence both the natural level of output and the natural real interest rate. However, the form of the aggregate demand equation is not a§ected, since this relation is expressed in terms of gap vari￾ables. Finally, we note that the compact form of the aggregate demand curve depends on the assumption of perfect capital markets, so that both the per￾manent income hypothesis for consumption and the q theory for investment are valid. As we discuss later, recent work relaxes the assumption of perfect capital markets. Aggregate Supply: The aggregate supply relation evolves from the price setting decisions of individual Örms. To capture nominal price inertia, it is assumed that Örms set prices on a staggered basis: each period a subset of Örms set their respective prices for multiple periods. Under the most common formulation, due to Calvo (1983), each period a Örm adjust its price with a Öxed probability that is independent of history.6 This assumption is not an unreasonable approximation of the evidence (Nakamura and Steinsson (2007) and Alvarez (2007)). Under áexible prices, during each period Örms set price equal to a constant markup over nominal marginal cost. With staggered price setting, Örms that are able to adjust in a given period set price equal to a weighted average 6The idea of using staggering to introduce nominal inertia is due to Fischer (1997) and Taylor (1980), who used it to describe nominal wage setting. A virtue of the Calvo formulation is that is facilitates aggregation. Because the adjustment probability is inde￾pendent of how long a Örm has kept its price Öxed, it is not necessary to keep track of when di§erent cohorts of Örms adjusted their prices. 12