and this “shift" parameter is included in the constant of a
standard inflation money growth relation.
The real balance correction (similar to the one used by
Keran and Zeldes for their article in this Review) is taken
over 12 quarters, in order to ‘smooth out’ any business-
cycle fluctuations in the real demand for money that might
be induced by variations in nominal money growth. Basi-
cally, this correction is designed to adjust for shifts in real
money demand that are unrelated to actual nominal money
changes but which tend to add ‘noise’ to the money-inflation
regression. An example of such a shift would be changes
in the real demand for various currencies as a result of the
switch from fixed to flexible rates, or changes due to financial
innovations that influence velocity. It should be noted that
this correction often affects the results substantially. Fre-
quently, the inclusion of this term substantially reduces the
regression standard error for the second period. Moreover,
the correction often substantially raises the estimate of
money's long-run impact upon prices for the second period.
Finally, in three cases the comparisons of the long-run im-
pacts between the two periods are affected by the correc-
tion: for Canada, the long-run impact declines from the first
to the second period when the correction is not included,
although again the change is fairly small and both impacts
remain well below unity; and for both Germany and the
Netherlands, the long-run impacts are negative in the sec-
ond period when the correction is not included (for Germany,
the dummy variable also substantially affects the results).
The results obtained by omitting the real money-demand
correction and dummy variable will be supplied upon re-
quest.
16. For example, suppose that an acceleration in money
growth is associated not only with an expectation of higher
future inflation but also with an increased risk of holding that
money. This increased risk may then reduce the real de-
mand for money in a way not captured by the interest rate
(i.e. it induces a shift in the real money-demand function).
17. Michael Darby (“Sterilization and Monetary Control un-
der Pegged Exchange Rates: Theory and Evidence,” NBER
Working Paper #449, February 1980) also finds that foreign
countries had very considerable short-run control over their
domestic money stocks during the adjustable-peg regime.
This suggests a general lack of bias in the Table I results
resulting from "feedback" from prices to money operating
via reserve flows. It is important to note that this argument
refers to the short-run; in the long-run, foreign money stocks
probably would have had to conform to the trend in U.S.
money. Rudimentary tests for a causal relation from prices
to money were also run for the two periods. Some feedback
from prices to money was detected for Japan and the U.K.,
and possibly Germany, for the earlier period. Interestingly,
there was some evidence of a feedback for Italy and Japan
for the later period. These results will also be supplied upon
request.
18. This, admittedly, is something of an oversimplification,
in that firms will also have to estimate costs over the con-
tract period in setting prices. The simple model in the Ap-
pendix assumes that firm supply is essentially exogenous
and fixed, so that the firm’s task is to estimate future de-
mand only. Taylor (1980) considers a more complex model
in which wages and price setting “interact,” but one which
yields similar results to those developed here. In still more
complex models, decisions regarding prices, investment,
inventory, and output are all interdependent. In these cases,
the dependence of prices on expected future money is not
likely to be as simple as the relation described in the Ap-
pendix.
19. This horizon need not, of course, be the same for all
agents. As indicated in the Appendix, when prices are set
by contracts, the horizon for permanent-money calculations
may depend upon the contract length. This horizon may
also be infinite, as in the case where aggregate demand
depends upon interest rates. Finally, the calculation of per-
manent money might involve discounting of expected future
m( ).
20. In particular, output responses to money and their ef-
fects upon aggregate demand are ignored. Taylor (1980)
considers wage-price interactions.
21. See the Appendix for further details. Contracts provide
one possible explanation for the Keran-Zeldes finding (in
their article in this Review) that the lag between money and
exchange rates is shorter than that between money and
prices. Specifically, exchange rates are free to adjust im-
mediately to permanent money changes, while price re-
sponses may be delayed by contracts.
22. See the Appendix for further details. It should be noted
that this does not require that interest rates significantly
affect aggregate demand. Bilson (1978) has noted that the
long-run effect of money on exchange rates will depend
upon the characteristics of the money-supply process.
23. Lucas’ (1970) statement applies here: “.. .the natural
rate hypothesis restricts the relationship of policy parame-
ters to behavioral parameters. It cannot be tested on a
behavioral relationship (Phillips curve, supply function, and
so on) alone.” (p. 57) Indeed, this is an elegant and succinct
statement of the basic arguments in the text about the
money-inflation relation. But there is also wide acceptance
of the opposing view—see for example Gittings (1979)—
that causal restrictions should be imposed on money-
inflation relations.
24. Evidence that money has “accommodated” domestic
variables, such as government deficits and wage increases,
can be found in Gordon (1977).
25. See Logue and Sweeney (1978), pp. 153-55.
26. In practice, countries may have occasionally varied
money growth so as to limit exchange-rate fluctuations.
Something like this occurred in 1978, when large interven-
tion in support of the dollar was partly responsible for sub-
stantial overshooting of money-growth targets in Germany
and Switzerland. There is also evidence for Japan (see my
“Rational Expectations and Countercyclical Monetary Pol-
icy: The Japanese Experience” in the Summer 1978 issue
of this Review) that the monetary authorities reacted to
Japanese-U.S. price shifts after 1971. In short, money
abroad may still be somewhat constrained by exchange-
rate considerations, so that the current floating-rate regime
differs only in degree from the former fixed-rate regime.
27. The model included moving-average terms at lags one,
two, and four (see the notes to Table II) as well as two
autoregressive parameters at lags one and two. The third
lag was omitted, as it generally was not statistically signi-
ficant. The long-run effects reported in the table are of-
48