One of The Stylized Facts that has been most important in shaping modern macroeconomic thought is the relatively sluggish response of wages and prices to changes in aggregate demand. This “stickiness” presents a major challenge to all theories that assume that prices adjust to equilibrate demand and supply. Indeed, its recognition led to the development of the Keynesian model and, more recently, to the nonmarket-clearing paradigm which is usually characterized by the assumption of some ad hoc gradual adjustment process. This assumption permits short-run deviations from “desired” equilibrium and is usually rationalized on the basis of adjustment costs. This approach has been widely applied in macroeconomic models (see Barro and Grossman (1976)) and is ubiquitous in the empirical literature on the demand for money. It has, nevertheless, been criticized for lacking a firm foundation of rational microeconomic behavior. 1 In its place a revival of equilibrium market models is occurring where contractual arrangements between the different economic agents give rise to the perceived sluggish price behavior. Previously, this effort has been directed to explaining unemployment. 2 The purpose of this paper is to extend this approach to the theory of money demand and the determination of the price level.
It is hoped that this paper will contribute to resolving a basic dilemma of modern monetarist theories of inflation, which can be described as follows. Money is one of many assets and as such its price (the inverse of the price level) should behave like any other asset price. Detailed observation of the markets for equity and other assets has led modern theoreticians to expect that asset prices adjust quickly to reflect all currently available information. Applying this theory to the demand for money, Sargent and Wallace (1973) show that the price level should change in the expectations of current and future monetary policy, implying that changes in the price level (the inflation rate) should be as unpredictable as changes in stock market prices. Even casual empiricism, however, yields the conclusion that the inflation rate is highly serially correlated and hence predictable, thereby contradicting predictions derived from the asset market theory.
Rather than rejecting this theory, economists have tended to regard it as a long-run proposition with little applicability to short-run behavior. For short-run analysis, two approaches have been taken. The more common one invokes the partial stock adjustment model for the demand for money. Unfortunately, this approach seems to be plagued with difficulties even on empirical grounds, since the estimated adjustment speeds are generally too slow to be credible and the money demand functions seem to be unstable over time. 3 The other approach, which is empirically untested, is to assume that goods market prices adjust slowly to changes in aggregate demand. 4 Although justified on quite different grounds, this approach yields very similar results to, and can be viewed as a special case of, the approach taken here.
This paper attempts to reconcile equilibrium theories of the demand for money with the empirical evidence. In particular, it will show that, even when all information is used efficiently and economic agents are always on their “desired” equilibrium demand schedules, the rate of inflation can exhibit strong serial correlation. Paralleling the recent literature on contractual arrangements in the labor market, this paper suggests that consumers enter into long-term contracts with producers. The upshot of this contractual arrangement is that some goods are sold in the spot market while others are sold at previously contracted prices. Since the latter are predetermined, only a portion of the price level (corresponding to the proportion of goods sold in the spot market) can adjust to reflect the new information; this process would then lead to an observed serial correlation of the inflation rate.
No attempt is made here to provide the microfoundations for such a market structure. Such a foundation would undoubtedly be based on risk diversification and information signaling services on the part of both consumers and producers. The market structure is left purposely vague in order to study the impact of money on price behavior under two theories of money demand. If one assumes that the proper deflator of money is the spot price index, this paper shows that the standard asset price behavior holds for an index of spot prices. The use of the general price index to test this theory then entails only a measurement error, and the observed serial correlation of the inflation rate cannot be used to contradict the asset view of money demand. On the other hand, if one assumes that money is deflated by the general price index, there is no measurement error, but then the spot price level tends to overshoot its long-run equilibrium position. 5
Section I describes the construction of a general price index when forward markets exist. Section II analyzes the impact on both the spot and general price levels under two assumptions about why money is held, Section III provides some empirically testable propositions that come out of this model, and Section IV presents a summary of conclusions.
American Economic Review, Papers and Proceedings, “Macroeconomics: An Appraisal of the Non-Market-Clearing Paradigm,” Vol. 69 (May 1979), pp. 54–69.
Black, Fischer, “Uniqueness of the Price Level in Monetary Growth Models with Rational Expectations,” Journal of Economic Theory, Vol. 7 (January 1974), pp. 53–65.
Blanchard, Olivier J., “Backward and Forward Solutions for Economies with Rational Expectations,” American Economic Review, Papers and Proceedings, Vol. 69 (May 1979), pp. 114–18.
Brillembourg, Arturo, “The Role of Savings in Flow Demand for Money: Alternative Partial Adjustment Models,” Staff Papers, Vol. 25 (June 1978), pp. 278–92.
Cargill, Thomas F., and Robert A. Meyer, “Stability of the Demand Function for Money: An Unresolved Issue,” American Economic Review, Papers and Proceedings, Vol. 69 (May 1979), pp. 318–23.
Carlson, John A., “Short-Term Interest Rates as Predictors of Inflation: Comment,” American Economic Review, Vol. 67 (June 1977), pp. 469–75.
Dornbusch, Rudiger, “Expectations and Exchange Rate Dynamics,” Journal of Political Economy, Vol. 84 (December 1976), pp. 1161–76.
Fama, Eugene F., “Interest Rates and Inflation: The Message in the Entrails,” American Economic Review, Vol. 67 (June 1977), pp. 487–96.
Grossman, Herschel I., “Why Does Aggregate Employment Fluctuate?” American Economic Review, Papers and Proceedings, Vol. 69 (May 1979), pp. 64–69.
Joines, Douglas, “Short-Term Interest Rates as Predictors of Inflation: Comment,” American Economic Review, Vol. 67 (June 1977), pp. 476–78.
Journal of International Economics, Vol. 8 (May 1978).
Magee, Stephen P., “Contracting and Spurious Deviations from Purchasing-Power Parity,” Ch.4 in The Economics of Exchange Rates: Selected Studies, ed. by Jacob A. Frenkel and Harry G. Johnson (Reading, Massachusetts, 1978), pp. 67–74.
Mussa, Michael, “Sticky Prices and Disequilibrium Adjustment in a Rational Model of the Inflation Process,” working paper, International Monetary Research Programme, London School of Economics and Political Science (January 1976).
Nelson, Charles R., and G. William Schwert, “Short-Term Interest Rates as Predictors of Inflation: On Testing the Hypothesis that the Real Rate of Interest is Constant,” American Economic Review, Vol. 67 (June 1977), pp. 478–86.
Roll, Richard, “Violations of Purchasing Power Parity and Their Implications for Efficient International Commodity Markets,” Ch. 6 in International Finance and Trade, Vol. 1, ed. by M. Sarnat and G. P. Szegö (Cambridge, Massachusetts, 1979), pp. 133–76.
Sargent, Thomas J., and Neil Wallace, “The Stability of Models of Money and Growth with Perfect Foresight,” Econometrica, Vol. 41 (November 1973), pp. 1043–48.
Taylor, John B., “Staggered Wage Setting in a Macro Model,” American Economic Review, Papers and Proceedings, Vol. 69 (May 1979), pp. 108–13.
Turnovsky, Stephen J., and Edwin Burmeister, “Perfect Foresight, Exceptional Consistency, and Macroeconomic Equilibrium,” Journal of Political Economy, Vol. 85 (April 1977), pp. 379–93.
White, William H., “Improving the Demand-for-Money Function in Moderate Inflation,” Staff Papers, Vol. 25 (September 1978), pp. 564–607.
Mr. Brillembourg, economist in the Special Studies Division of the Research Department, is a graduate of Harvard University and of the University of Chicago.
See the section, “Macroeconomics: An Appraisal of the Non-Market-Clearing Paradigm,” American Economic Review, Papers and Proceedings (May 1979), pp. 54–69.
This is the counterpart of the overshooting hypothesis of the exchange rate in the open economy with sticky prices; see Dornbusch (1976).
This assumption rules out average cost pricing of contracts, that is, the issuing of a contract that allows the transaction to take place at a fixed price and at any time from now to, say, six months hence. (The reader will recognize this to be akin to an option rather than a forward contract.) While allowing for this possibility may be more realistic in that it models sticky prices and recognizes the cost of issuing forward contracts, it does not change the substance of the argument but does complicate it greatly.
A more general formulation would recognize that these weights are determined by the behavior of the agents in the economy and, thus, cannot be taken as given. Indeed, it is likely that their distribution depends on the variability of inflation, among other things. The determination of these weights is left for future research.
Note that in both cases the alternative of holding money is holding goods; hence, the opportunity cost of holding money is the expected appreciation of goods in terms of money. The fact that individuals can issue future contracts does not change this trade-off in the aggregate.
This equation is similar in structure to one proposed by Mussa (1976), derived under the assumption of sticky prices. Because of the different approach taken, however, the interpretation and, consequently, the use which can be made of it are quite different.
As in Section II, one can assume that the appropriate deflator for cash balances is a weighted average of both the spot and general price levels. Unfortunately, the resulting models will not be empirically distinguishable from those that deflate only by the spot price level.
See Journal of International Economics, Vol. 8 (May 1978), which is devoted to a discussion of PPP-related issues.