Expectations, Money, and the
Forecasting of Inflation
Charles Pigott*
Economists continue to debate whether
money is the only or even the primary cause
of inflation. Few, however, would deny that
money affects inflation with a lag. This propo-
sition has been confirmed by studies of a va-
riety of countries and historical periods. In
most cases, money’s effect upon prices has
been found to continue for several years’ time,
although the precise lag often seems to vary
substantially.1
Partly as a result of these studies, estimates
of the lagged relation between money and
prices are widely used for such purposes as
forecasting inflation. But this lagged relation
has implications that go well beyond the pre-
diction of inflation. If money changes are not
immediately and fully reflected in prices, they
will lead in the short run to variations in real
balances and real liquidity, which in turn may
affect interest rates and real aggregate de-
mand. Indeed, it is widely believed that money
affects real economic activity in the short run
because its impact upon prices is delayed.2 This
view is reflected in many of the formal econo-
metric models used in business and govern-
ment, where the timing of money’s impact
upon prices is critical in determining short-run
effects of monetary policy on the real sector.
But despite its widespread application, little
is known empirically about the factors deter-
mining the money-inflation lag. Indeed, the
very reasons for its existence are controversial.
A common and traditional view is that the lag
stems from institutional and technical factors—
‘Economist, Federal Reserve Bank of San Francisco.
Kirk McAlIister and Christopher Dunn provided research
assistance for this article.
e.g., contracts and adjustment costs— that
prevent prices from adjusting immediately to
money changes. Also, according to this view,
such factors presumably are unaffected by
monetary policy. This proposition, if true,
greatly simplifies the task of policy analysts,
since it implies that estimates of the money-
inflation relation derived under one type of pol-
icy will remain valid under another. Past be-
havior, that is, provides a relatively unambig-
uous guide to the future in this case.
In recent years, with the growing under-
standing of the influence of individuals’ expec-
tations upon behavior, such mechanistic views
of the lags in economic relations have been
challenged. Few would deny that institutional
and technical “frictions” such as contracts, ad-
justment costs, and imperfect information are
partly responsible for the lag between money
and prices. Nonetheless, basic economic the-
ory suggests that the decisions individuals
make when faced with such factors often de-
pend critically upon their anticipations about
the future. In some industries, for example,
contractual arrangements prevent prices from
adjusting immediately to a change in money.
It could be supposed that anticipations have
little or no influence upon the length and gen-
eral form of such contracts, since these fea-
tures often are largely determined by custom,
law, and industry characteristics. But the price
specified in any contract will depend upon firm
perceptions of future costs and demand, and
hence implicitly upon judgments about future
inflation and (thus) monetary policy.
This suggests that the lags in money-infla-
tion as well as other economic relations result
from the interaction of two basic sets of fac-
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