Laurence Ball, N. Gregory Mankiw, and David Romer the macroeconomic effects of nominal rigidity differ from the private costs because rigidity has an aggregate demand externality 'A fev equations make this clear. Suppose the demand for the product of firm i depends on aggregate spending and on the firms relative price For simplicity, aggregate demand is given by a quantity equation? M Combining equations 2 and 3 yield MVP Y According to equation 4, firm is demand depends on its relative price and on real money, which determines aggregate demand. Changes in real money shift the demand curve facing firm i, and the firms price determines its position on the demand curve. If M falls and firm i does not adjust, the second- order cost to firm i is that Pi/P does not adjust to the new profit-maximizing level. The externality is that rigidity in firm is price contributes to rigidity in the aggregate price level. Given the fall in nominal money, rigidity in P implies a first-order fall in real money, which reduces demand for all firms' goods. In other words, there is an externality because adjustment of all prices would prevent a fall in real aggregate demand, but each firm is a small part of the economy and thus ignores this macroeconomic he importance of the externality is illustrated by a firm in a recession caused by tight money. To the firm, the recession means an inward shift of its demand curve and a resulting first-order loss in profits. The firm would very much like to shift its demand curve back out, but of course it cannot do so by changing its price. Instead, price adjustment would yield only the second-order gain from optimally dividing the losses from 7. The only essential feature of equation 3 is the negative relation between Y and P. I interpret M as simply a shift term in the aggregate demand equation. Thus, as we below, the results in recent papers concern the effects shock to aggregate demand not just changes in the money stock