Laurence Ball, N. Gregory Mankiw, and David Romer Thus it is difficult to explain the relation of output to nominal variables without nominal rigidities Nominal rigidities are also important for explaining the effects of real shocks to aggregate demand, resulting for example from changes in government spending or in the expectations of investors. The point is clear if we interpret M in the aggregate demand equation, y= M/P, as imply a shift term, in which case real disturbances that shift demand affect output through the same channels as changes in money Not all explanations for the output effects of real demand shocks pend on nominal imperfections. robert Barros model of government purchases, for one, does not. 9 But such explanations invoke implausibly large labor supply elasticities. Thus nominal rigidities, while not the only explanation for the effects of real demand, are perhaps the most appea In the models we have surveyed slow adjustment of prices implies that shocks cause temporary deviations of output and employment from their"natural rates. Recently, however, models of hysteresis, in which shocks have permanent effects, have become popular. For example Blanchard and Summers argue that the natural rate of unemployment in European countries changes when actual unemployment changes, so that there is no unique level to which unemployment returns. 20 If these theories are correct, then nominal rigidities cannot fully explain unem ployment, because nominal prices eventually adjust to shocks; some dditional explanation, such as the insider-outsider model in Blanchard and Summers, is needed for the persistence of unemployment. But nominal rigidities may be crucial for explaining the initial impulse unemployment. For example, after rising during the late 1970s, unem- ployment in Britain has remained high, suggesting hysteresis. But the best explanation for the original increase is arguably a conventional one low adjustment of wages and prices to shocks like tight monetary policy and increases in import prices The Importance of Externalities from Rigidity. Externalities from minai rigidity, the central element of menu cost models, are essential 19. Robert J. Barro, Output Effects of Government Purchases, " Journal of political Economy, vol. 89(December 1981), pp. 1086-1121 20. Olivier J. Blanchard and Lawrence Summers,""Hysteresis and the European Unemployment Problem, " "in Stanley Fischer, ed, NBER Macroeconomics AnnuaL, 1986 ( MIT Press,1986),pp.15-78