and declining when it is black. Average money
changes will then be zero, but at any given
time the level of money expected in the future
will be the same as what is now prevailing
(Case 2). The level of expected future money,
and thus permanent money, will then shift up
and down with current money growth. That is,
a rise in current money will signal an increase
in permanent money and thus a proportional
increase in prices. Inflation and current money
growth will certainly be related— and inflation
may also be related to past money growth if
contracts prevent some industries from adjust-
ing immediately—and the long-run impact of
current money growth on prices will be unity.
Finally, consider the case where money
growth exceeds its long-run average and re-
mains above target in succeeding periods. In-
dividuals perceiving this pattern will then raise
their estimates Ofpermanent money more than
proportionally whenever they observe money
growth rising (Case 3). Such accelerations
generally will lead eventually to more-than-
proportionate increases in the price level, so
that the measured impact of money on prices
in this case will be greater than one.
To summarize, we argue that a money-price
forecasting relation reflects the way in which
individuals predict future money, not primarily
the causal links between money and prices.23
If true, this has several important implications
for the forecasting of future prices, and hence
inflation. First, the total effect of money on
prices measured from such relations generally
will not be unity, and should not be constrained
to be so. The more persistent the current
money changes, the more they will ultimately
affect prices. Second, when other variables,
such as government deficits, provide informa-
tion about both past and future money, they
should be used in the forecasting of inflation.
Even if money were the only direct cause of
inflation, accurate predictions of prices gener-
ally will also involve other variables; in other
words, because of the complex social and po-
litical nature of inflation, individuals should rely
on more than the past history of money in
predicting its future.24
How important are these considerations in
practice? Consider the case where the mone-
tary authorities switch from a policy of offset-
ting monetary deviations to one of constant
accelerated growth. So long as individuals con-
tinue to predict future money as before, infla-
tion forecasters utilizing data based on the in-
itial policy will continue to be reasonably
successful. But once individuals learn of the
new policy, the old forecasting relation will
seriously underpredict inflation. This relation
will predict relatively small price responses be-
cause it is based upon a period in which money
changes were normally transient; once individ-
uals learn that new money changes are more
permanent, actual price responses will be
much greater.
Evidence Reconsidered
Our arguments help explain certain features
of the money-inflation relation summarized in
Table 1. As we saw, the long-run impact of
money on prices was greatest for the U.S. Fur-
thermore, the long-run impact was generally
higher during the 1970’s than during the
1960’s; the impact generally was below one
during the 1960’s, but equal to or above one
during the 1970’s. However, our permanent
money-inflation theory suggests an explanation
for this shift, based on the different interna-
tional monetary arrangements prevailing dur-
ing the two decades.
During the 1960’s, foreign nations at-
tempted to maintain a fixed value for their
currencies in terms of the dollar. Such a policy
required that foreign prices rise at the same
rate as those in the U.S., at least on average.
This in turn meant that foreign money growth
was effectively constrained by U.S. growth. If
foreign money growth was too high, for ex-
ample, prices of traded goods produced abroad
would tend to rise faster than those in the
U.S., eroding the competitiveness of foreign
industries. The resulting trade and balance-of-
payments deficits then would render such a
policy incompatible with maintenance of a
fixed exchange rate. In effect, foreign money
39