tors. On the one hand, there are various “fric-
tions” and “imperfections”—factors that are
determined largely by technology, precedent,
law, and other institutional characteristics that
change very slowly with anticipations, and
then only if these depart fairly radically from
past experience. But interacting with these fac-
tors are individuals’ expectations, particularly
their perceptions as to how current and past
conditions relate to those in the future. Given
that interaction, the lag between money and
prices (and analogous lags in other economic
relations) is likely to change when government
policies are altered, because then individuals’
expectations can be expected to change.
Plainly then, the extent to which expecta-
tions influence the money-inflation lag has
potentially far-reaching practical implications
for policy formulation. If expectations are im-
portant, the relations used to predict inflation
and real-output responses to money are apt to
shift when basic policy is altered. To assess the
effects of alternative policies realistically, we
are likely to need an explicit identification of
the role of expectations in determining the
money-inflation lag, because only in this way
will we be able to predict shifts in the relation.
If expectations are as important as some econ-
omists believe, policy analysts will have to con-
sider them more explicitly than they generally
have in the past.
This paper discusses how expectations about
monetary policy may affect the lag between
money and prices. Basically, we argue that
price decisions made now are likely to be
based upon individuals’ anticipations about the
level of money in the future. If true, the con-
sequences are very important for the forecast-
ing of inflation, the evaluation of prospective
policies, and the testing of alternative theories
of inflation. Normally, inflation forecasts are
based upon data on current and past money
growth and, in some cases, other variables; the
same relations are usually employed in pre-
dicting the impact of prospective policies. If
prices are actually based upon forecasts of fu-
ture money, such relations will reflect the way
in which predictions of future money are cal-
culated from current and past data. For this
reason, basic changes in monetary policy are
likely to alter the lag between money and
prices, because such changes are likely to lead
individuals (at least eventually) to revise their
forecasting methods. Following Lucas (1970)
and Sargent and Wallace (1976), our arguments
criticize those procedures which use economic
relations observed under one set of policies to
predict the consequences of different policies.
Section I of the paper summarizes explana-
tions that have been offered for the lag be-
tween money and prices. Nearly all of these
explanations suggest that prices will be based,
directly or indirectly, upon forecasts of future
money (see appendix for technical details).
Estimates presented for several countries sug-
gest, tentatively, that expectations may have
significantly influenced money-inflation lags. For
policy purposes, however, we must identify the
way in which expectations affect such empiri-
cal relations between money and prices; only
then can we determine how inflation-forecasting
methods must be revised when policy is al-
tered.
In Section II we discuss the implications of
a relatively simple but potentially powerful hy-
pothesis—that prices respond more to money
changes that are perceived as permanent or
persistent than to those seen as transient, with
that response itself being relatively unaffected
by policy. This suggests that the empirical re-
lation between inflation and actual money will
depend crucially upon how individuals view
the future sustainability of such changes in
money. The (crude) evidence cited here pro-
vides only mixed support for this view, but the
hypothesis merits further research.
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