This chapter reviews the role of temporary price and wage rigidities in explaining of the dynamic relationship between money, real output, and inflation. The key properties to be explained are that monetary shocks have persistent, but not permanent, effects on real output, and that the correlation between current output and inflation is positive for leads of inflation and negative for lags of inflation. The paper begins with a short empirical guide to price- and wage-setting behavior in market economies. It then compares alternative price- and wage-setting theories and argues that staggered contracts models continue to provide the most satisfactory match with the key macroeconomic facts. It then examines the microeconomic foundations of staggered contracts models and reviews some of their extensions and applications. Research in this area has been very active in the 1990s with a remarkable number of studies using, estimating, or testing models of staggered price and wage setting. A new generation of econometric models incorporating staggered price and wage setting with rational expectations has been built. Researchers have begun to incorporate staggered wage and price setting into real business cycle models. Close links have been discovered between the parameters of people's utility functions and the parameters of staggered price- and wage-setting equations. There is now a debate about whether standard calibrations of utility functions prevent staggered price models, at least those with frequent price changes, from explaining long persistence of real output. A theme of the paper is that the advent of rational expectations in the 1970s led to models of price and wage rigidities which were more amenable to empirical testing than earlier models, and this is one reason for the recent controversies and debates. There is much to be discovered from these debates and from the future research they stimulate.
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