diff --git a/src/lib/autocomplete/_autocomplete-theme.scss b/src/lib/autocomplete/_autocomplete-theme.scss
index 3e231a63148d..cf5bc6e609a1 100644
--- a/src/lib/autocomplete/_autocomplete-theme.scss
+++ b/src/lib/autocomplete/_autocomplete-theme.scss
@@ -9,7 +9,7 @@
     color: md-color($foreground, text);
 
     md-option {
-      &.md-selected {
+      &.md-selected:not(.md-active) {
         background: md-color($background, card);
         color: md-color($foreground, text);
       }
diff --git a/src/lib/autocomplete/autocomplete-trigger.ts b/src/lib/autocomplete/autocomplete-trigger.ts
index 42d623b88da1..4e87b4eea70b 100644
--- a/src/lib/autocomplete/autocomplete-trigger.ts
+++ b/src/lib/autocomplete/autocomplete-trigger.ts
@@ -1,12 +1,14 @@
 import {
-  Directive, ElementRef, Input, ViewContainerRef, Optional, OnDestroy
+    AfterContentInit, Directive, ElementRef, Input, ViewContainerRef, Optional, OnDestroy
 } from '@angular/core';
 import {NgControl} from '@angular/forms';
 import {Overlay, OverlayRef, OverlayState, TemplatePortal} from '../core';
 import {MdAutocomplete} from './autocomplete';
 import {PositionStrategy} from '../core/overlay/position/position-strategy';
 import {Observable} from 'rxjs/Observable';
-import {MdOptionSelectEvent} from '../core/option/option';
+import {MdOptionSelectEvent, MdOption} from '../core/option/option';
+import {ActiveDescendantKeyManager} from '../core/a11y/activedescendant-key-manager';
+import {ENTER} from '../core/keyboard/keycodes';
 import 'rxjs/add/observable/merge';
 import {Dir} from '../core/rtl/dir';
 import 'rxjs/add/operator/startWith';
@@ -19,14 +21,19 @@ export const MD_AUTOCOMPLETE_PANEL_OFFSET = 6;
 @Directive({
   selector: 'input[mdAutocomplete], input[matAutocomplete]',
   host: {
-    '(focus)': 'openPanel()'
+    '(focus)': 'openPanel()',
+    '(keydown)': '_handleKeydown($event)',
+    'autocomplete': 'off'
   }
 })
-export class MdAutocompleteTrigger implements OnDestroy {
+export class MdAutocompleteTrigger implements AfterContentInit, OnDestroy {
   private _overlayRef: OverlayRef;
   private _portal: TemplatePortal;
   private _panelOpen: boolean = false;
 
+  /** Manages active item in option list based on key events. */
+  private _keyManager: ActiveDescendantKeyManager;
+
   /* The autocomplete panel to be attached to this trigger. */
   @Input('mdAutocomplete') autocomplete: MdAutocomplete;
 
@@ -34,6 +41,10 @@ export class MdAutocompleteTrigger implements OnDestroy {
               private _viewContainerRef: ViewContainerRef,
               @Optional() private _controlDir: NgControl, @Optional() private _dir: Dir) {}
 
+  ngAfterContentInit() {
+    this._keyManager = new ActiveDescendantKeyManager(this.autocomplete.options);
+  }
+
   ngOnDestroy() { this._destroyPanel(); }
 
   /* Whether or not the autocomplete panel is open. */
@@ -69,8 +80,11 @@ export class MdAutocompleteTrigger implements OnDestroy {
    * when an option is selected and when the backdrop is clicked.
    */
   get panelClosingActions(): Observable<any> {
-    // TODO(kara): add tab event observable with keyboard event PR
-    return Observable.merge(...this.optionSelections, this._overlayRef.backdropClick());
+    return Observable.merge(
+        ...this.optionSelections,
+        this._overlayRef.backdropClick(),
+        this._keyManager.tabOut
+    );
   }
 
   /** Stream of autocomplete option selections. */
@@ -78,6 +92,19 @@ export class MdAutocompleteTrigger implements OnDestroy {
     return this.autocomplete.options.map(option => option.onSelect);
   }
 
+  /** The currently active option, coerced to MdOption type. */
+  get activeOption(): MdOption {
+    return this._keyManager.activeItem as MdOption;
+  }
+
+  _handleKeydown(event: KeyboardEvent): void {
+    if (this.activeOption && event.keyCode === ENTER) {
+      this.activeOption._selectViaInteraction();
+    } else {
+      this.openPanel();
+      this._keyManager.onKeydown(event);
+    }
+  }
 
   /**
    * This method listens to a stream of panel closing actions and resets the
@@ -90,7 +117,10 @@ export class MdAutocompleteTrigger implements OnDestroy {
         .startWith(null)
         // create a new stream of panelClosingActions, replacing any previous streams
         // that were created, and flatten it so our stream only emits closing events...
-        .switchMap(() => this.panelClosingActions)
+        .switchMap(() => {
+          this._resetActiveItem();
+          return this.panelClosingActions;
+        })
         // when the first closing event occurs...
         .first()
         // set the value, close the panel, and complete.
@@ -149,5 +179,10 @@ export class MdAutocompleteTrigger implements OnDestroy {
     return this._element.nativeElement.getBoundingClientRect().width;
   }
 
+  /** Reset active item to -1 so DOWN_ARROW event will activate the first option.*/
+  private _resetActiveItem(): void {
+    this._keyManager.setActiveItem(-1);
+  }
+
 }
 
diff --git a/src/lib/autocomplete/autocomplete.spec.ts b/src/lib/autocomplete/autocomplete.spec.ts
index bc02469a4d43..c2d540df343d 100644
--- a/src/lib/autocomplete/autocomplete.spec.ts
+++ b/src/lib/autocomplete/autocomplete.spec.ts
@@ -1,5 +1,5 @@
 import {TestBed, async, ComponentFixture} from '@angular/core/testing';
-import {Component, OnDestroy, ViewChild} from '@angular/core';
+import {Component, OnDestroy, QueryList, ViewChild, ViewChildren} from '@angular/core';
 import {By} from '@angular/platform-browser';
 import {MdAutocompleteModule, MdAutocompleteTrigger} from './index';
 import {OverlayContainer} from '../core/overlay/overlay-container';
@@ -7,6 +7,8 @@ import {MdInputModule} from '../input/index';
 import {Dir, LayoutDirection} from '../core/rtl/dir';
 import {FormControl, ReactiveFormsModule} from '@angular/forms';
 import {Subscription} from 'rxjs/Subscription';
+import {ENTER, DOWN_ARROW, SPACE} from '../core/keyboard/keycodes';
+import {MdOption} from '../core/option/option';
 
 describe('MdAutocomplete', () => {
   let overlayContainerElement: HTMLElement;
@@ -205,7 +207,7 @@ describe('MdAutocomplete', () => {
       fixture.detectChanges();
 
       expect(input.value)
-          .toContain('California', `Expected text field to be filled with selected value.`);
+          .toContain('California', `Expected text field to fill with selected value.`);
     });
 
     it('should mark the autocomplete control as dirty when an option is selected', () => {
@@ -236,6 +238,159 @@ describe('MdAutocomplete', () => {
 
   });
 
+  describe('keyboard events', () => {
+    let fixture: ComponentFixture<SimpleAutocomplete>;
+    let input: HTMLInputElement;
+    let DOWN_ARROW_EVENT: KeyboardEvent;
+    let ENTER_EVENT: KeyboardEvent;
+
+    beforeEach(() => {
+      fixture = TestBed.createComponent(SimpleAutocomplete);
+      fixture.detectChanges();
+
+      input = fixture.debugElement.query(By.css('input')).nativeElement;
+      DOWN_ARROW_EVENT = new FakeKeyboardEvent(DOWN_ARROW) as KeyboardEvent;
+      ENTER_EVENT = new FakeKeyboardEvent(ENTER) as KeyboardEvent;
+    });
+
+    it('should should not focus the option when DOWN key is pressed', () => {
+      fixture.componentInstance.trigger.openPanel();
+      fixture.detectChanges();
+
+      spyOn(fixture.componentInstance.options.first, 'focus');
+
+      fixture.componentInstance.trigger._handleKeydown(DOWN_ARROW_EVENT);
+      expect(fixture.componentInstance.options.first.focus).not.toHaveBeenCalled();
+    });
+
+    it('should set the active item to the first option when DOWN key is pressed', async(() => {
+      fixture.componentInstance.trigger.openPanel();
+      fixture.detectChanges();
+
+      const optionEls =
+          overlayContainerElement.querySelectorAll('md-option') as NodeListOf<HTMLElement>;
+
+      fixture.componentInstance.trigger._handleKeydown(DOWN_ARROW_EVENT);
+
+      fixture.whenStable().then(() => {
+        fixture.detectChanges();
+        expect(fixture.componentInstance.trigger.activeOption)
+            .toBe(fixture.componentInstance.options.first, 'Expected first option to be active.');
+        expect(optionEls[0].classList).toContain('md-active');
+        expect(optionEls[1].classList).not.toContain('md-active');
+
+        fixture.componentInstance.trigger._handleKeydown(DOWN_ARROW_EVENT);
+
+        fixture.whenStable().then(() => {
+          fixture.detectChanges();
+          expect(fixture.componentInstance.trigger.activeOption)
+              .toBe(fixture.componentInstance.options.toArray()[1],
+                  'Expected second option to be active.');
+          expect(optionEls[0].classList).not.toContain('md-active');
+          expect(optionEls[1].classList).toContain('md-active');
+        });
+      });
+    }));
+
+    it('should set the active item properly after filtering', async(() => {
+      fixture.componentInstance.trigger.openPanel();
+      fixture.detectChanges();
+
+      fixture.componentInstance.trigger._handleKeydown(DOWN_ARROW_EVENT);
+
+      fixture.whenStable().then(() => {
+        fixture.detectChanges();
+        input.value = 'o';
+        dispatchEvent('input', input);
+        fixture.detectChanges();
+
+        const optionEls =
+            overlayContainerElement.querySelectorAll('md-option') as NodeListOf<HTMLElement>;
+
+        fixture.componentInstance.trigger._handleKeydown(DOWN_ARROW_EVENT);
+
+        fixture.whenStable().then(() => {
+          fixture.detectChanges();
+          expect(fixture.componentInstance.trigger.activeOption)
+              .toBe(fixture.componentInstance.options.first, 'Expected first option to be active.');
+          expect(optionEls[0].classList).toContain('md-active');
+          expect(optionEls[1].classList).not.toContain('md-active');
+        });
+      });
+    }));
+
+    it('should fill the text field when an option is selected with ENTER', () => {
+      fixture.componentInstance.trigger.openPanel();
+      fixture.detectChanges();
+
+      fixture.componentInstance.trigger._handleKeydown(DOWN_ARROW_EVENT);
+      fixture.componentInstance.trigger._handleKeydown(ENTER_EVENT);
+      fixture.detectChanges();
+
+      expect(input.value)
+          .toContain('Alabama', `Expected text field to fill with selected value on ENTER.`);
+    });
+
+    it('should fill the text field, not select an option, when SPACE is entered', () => {
+      fixture.componentInstance.trigger.openPanel();
+      fixture.detectChanges();
+
+      input.value = 'New';
+      dispatchEvent('input', input);
+      fixture.detectChanges();
+
+      const SPACE_EVENT = new FakeKeyboardEvent(SPACE) as KeyboardEvent;
+      fixture.componentInstance.trigger._handleKeydown(DOWN_ARROW_EVENT);
+      fixture.componentInstance.trigger._handleKeydown(SPACE_EVENT);
+      fixture.detectChanges();
+
+      expect(input.value)
+          .not.toContain('New York', `Expected option not to be selected on SPACE.`);
+    });
+
+    it('should mark the control as dirty when an option is selected from the keyboard', () => {
+      fixture.componentInstance.trigger.openPanel();
+      fixture.detectChanges();
+
+      expect(fixture.componentInstance.stateCtrl.dirty)
+          .toBe(false, `Expected control to start out pristine.`);
+
+      fixture.componentInstance.trigger._handleKeydown(DOWN_ARROW_EVENT);
+      fixture.componentInstance.trigger._handleKeydown(ENTER_EVENT);
+      fixture.detectChanges();
+
+      expect(fixture.componentInstance.stateCtrl.dirty)
+          .toBe(true, `Expected control to become dirty when option was selected by ENTER.`);
+    });
+
+    it('should open the panel again when typing after making a selection', async(() => {
+      fixture.componentInstance.trigger.openPanel();
+      fixture.detectChanges();
+
+      fixture.componentInstance.trigger._handleKeydown(DOWN_ARROW_EVENT);
+      fixture.componentInstance.trigger._handleKeydown(ENTER_EVENT);
+      fixture.detectChanges();
+
+      fixture.whenStable().then(() => {
+        expect(fixture.componentInstance.trigger.panelOpen)
+            .toBe(false, `Expected panel state to read closed after ENTER key.`);
+        expect(overlayContainerElement.textContent)
+            .toEqual('', `Expected panel to close after ENTER key.`);
+
+        // 65 is the keycode for "a"
+        const A_KEY = new FakeKeyboardEvent(65) as KeyboardEvent;
+        fixture.componentInstance.trigger._handleKeydown(A_KEY);
+        fixture.detectChanges();
+
+        expect(fixture.componentInstance.trigger.panelOpen)
+            .toBe(true, `Expected panel state to read open when typing in input.`);
+        expect(overlayContainerElement.textContent)
+            .toContain('Alabama', `Expected panel to display when typing in input.`);
+      });
+    }));
+
+  });
+
 });
 
 @Component({
@@ -257,6 +412,7 @@ class SimpleAutocomplete implements OnDestroy {
   valueSub: Subscription;
 
   @ViewChild(MdAutocompleteTrigger) trigger: MdAutocompleteTrigger;
+  @ViewChildren(MdOption) options: QueryList<MdOption>;
 
   states = [
     {code: 'AL', name: 'Alabama'},
@@ -301,4 +457,11 @@ function dispatchEvent(eventName: string, element: HTMLElement): void {
   element.dispatchEvent(event);
 }
 
+/** This is a mock keyboard event to test keyboard events in the autocomplete. */
+class FakeKeyboardEvent {
+  constructor(public keyCode: number) {}
+  preventDefault() {}
+}
+
+
 
diff --git a/src/lib/core/option/_option-theme.scss b/src/lib/core/option/_option-theme.scss
index f639cdfb42f2..2b22c8ff4f58 100644
--- a/src/lib/core/option/_option-theme.scss
+++ b/src/lib/core/option/_option-theme.scss
@@ -16,6 +16,11 @@
       color: md-color($primary);
     }
 
+    &.md-active {
+      background: md-color($background, hover);
+      color: md-color($foreground, text);
+    }
+
     &.md-option-disabled {
       color: md-color($foreground, hint-text);
     }
diff --git a/src/lib/core/option/option.ts b/src/lib/core/option/option.ts
index 2c7e0f9e85c7..9d714fafc99d 100644
--- a/src/lib/core/option/option.ts
+++ b/src/lib/core/option/option.ts
@@ -36,6 +36,7 @@ export class MdOptionSelectEvent {
     'role': 'option',
     '[attr.tabindex]': '_getTabIndex()',
     '[class.md-selected]': 'selected',
+    '[class.md-active]': 'active',
     '[id]': 'id',
     '[attr.aria-selected]': 'selected.toString()',
     '[attr.aria-disabled]': 'disabled.toString()',
@@ -48,6 +49,7 @@ export class MdOptionSelectEvent {
 })
 export class MdOption {
   private _selected: boolean = false;
+  private _active: boolean = false;
 
   /** Whether the option is disabled.  */
   private _disabled: boolean = false;
@@ -75,6 +77,16 @@ export class MdOption {
     return this._selected;
   }
 
+  /**
+   * Whether or not the option is currently active and ready to be selected.
+   * An active option displays styles as if it is focused, but the
+   * focus is actually retained somewhere else. This comes in handy
+   * for components like autocomplete where focus must remain on the input.
+   */
+  get active(): boolean {
+    return this._active;
+  }
+
   /**
    * The displayed value of the option. It is necessary to show the selected option in the
    * select's trigger.
@@ -100,6 +112,24 @@ export class MdOption {
     this._renderer.invokeElementMethod(this._getHostElement(), 'focus');
   }
 
+  /**
+   * This method sets display styles on the option to make it appear
+   * active. This is used by the ActiveDescendantKeyManager so key
+   * events will display the proper options as active on arrow key events.
+   */
+  setActiveStyles() {
+    Promise.resolve(null).then(() => this._active = true);
+  }
+
+  /**
+   * This method removes display styles on the option that made it appear
+   * active. This is used by the ActiveDescendantKeyManager so key
+   * events will display the proper options as active on arrow key events.
+   */
+  setInactiveStyles() {
+    Promise.resolve(null).then(() => this._active = false);
+  }
+
   /** Ensures the option is selected when activated from the keyboard. */
   _handleKeydown(event: KeyboardEvent): void {
     if (event.keyCode === ENTER || event.keyCode === SPACE) {