The New Keynesian Economics and the Output-Inflation Trade-Off

The purpose of this paper is to provide evidence supporting new Keynesian theories. We point out a simple prediction of Keynesian models that contradicts other leading macroeconomic theories and show that it holds in actual economies. In doing so, we point out a "new phenomenon" that Keynesian theories "render comprehensible." The prediction we that we test concerns the effects of steady inflation. In Keynesian models, nominal shocks have real effects because nominal prices change infrequently. An increase in the average rate of inflation causes firms to adjust prices more frequently to keep up with the rising price level. In turn, more frequent price changes imply that prices adjust more quickly to nominal shocks, and thus that the shocks have smaller real effects. We test this prediction by examining the relation between average inflation and the size of the real effects of nominal shocks both across countries and over time. We measure the effects of nominal shocks by the slope of the short-run Phillips curve