Consider the economy of Freeland, whose overall actual price index and actual output are P and Y respectively, and the natural rate of output is Yˉ . There are two types of firms in Freeland: firms with flexible prices, which set prices according to p = P + 0.5(Y − Yˉ ); and firms with sticky prices, which set prices base on p = Pe (the expected overall price index). Also the fraction of firms with sticky prices is s = 0.75.
