Aggregate Supply and Potential Output

The New-Keynesian aggregate supply derives from micro-foundations an inflation-dynamics model very much like the tradition in the monetary literature. Inflation is primarily affected by: (i) economic slack; (ii) expectations; (iii) supply shocks; and (iv) inflation persistence. This paper extends the New Keynesian aggregate supply relationship to include also fluctuations in potential output, as an additional determinant of the relationship. Implications for monetary rules and to the estimation of the Phillips curve are pointed out.