I. Lags Between Money and Prices
In the long-run, it is widely believed, sus-
tained changes in money merely lead to vari-
ations in all prices in the same proportion with-
out affecting real output, interest rates, or
relative prices. (“Sustained” changes are those
that are neither augmented nor diminished in
the future.) This proposition, which is known
as the (long-run) neutrality of money, is based
intuitively on the fact that a rise in money and
all prices in the same proportion leaves the
“typical” individual’s real balances, real
wealth, and real income unaffected; since that
individual’s consumption, savings, work, and
leisure opportunities are unaltered by the
money change, his decisions similarly should
not be affected.3 A substantial amount of evi-
dence suggests, at least for the U.S., that
money is at least approximately neutral in this
sense.4 Of course the neutrality of money does
not imply that money changes are the only
sources of change in the aggregate price level;
it is also affected by changes in real income,
interest rates, oil prices and other variables
which influence the demand for money. How-
ever, historical studies, particularly the mon-
umental Monetary History of the United States
by Friedman and Schwartz (1963), have estab-
lished that variations in money growth account
for most variations in long-term inflation rates.
This long-run relation suggests the use of
money to predict inflation in the short-run.
However, even casual observation reveals that
money changes do not lead immediately to
proportional changes in the price level, but
that they are associated initially with changes
in real output and interest rates. Most econo-
mists would agree that this short-run departure
from neutrality originates in factors that pre-
vent prices from responding immediately and
proportionately to money changes, and that
the subsequent change in real balances leads
to interest-rate and real-output changes that
further influence the “transmission” of money
to prices.
More formally, we can distinguish between
long-run and short-run effects. In the long-run,
prices vary proportionately with nominal ag-
gregate demand, which itself changes in the
same proportion as money. In the short-run,
however, money is not fully reflected in prices,
but “spills over” into real income and interest
rates, which in turn influence aggregate demand
and prices. This series of adjustments of prices
to money, direct as well as via money’s effect
on output and interest rates, is reflected in re-
lations used to predict prices and inflation from
money-growth data. Such relations are com-
monly written in the form,
p(t) = a0m(t) + aɪm(t-l) +
. . .anm(t-n) + z(t) (1)
or more commonly in change-form as
∆p(t) = ao∆m(t) + a1∆m(t-l) +
. . .an∆m(t-n) + ∆z(t) (T)
where p is the log of aggregate prices, m is the
log of the money stock, and z(t) stands for all
other non-monetary variables affecting prices,
such as long-run trends in real output and
money velocity; here ∆p(t) refers to the change
in p(), that is p(t)-p(t-l) and similarly for
∆m(t).5 Again, the lags reflect not only money’s
direct effect upon prices but also its indirect
effects operating via short-run changes in real
output and interest rates.6 What is the source
of these lags, and how may they be influenced
by individuals’ expectations about monetary
policy?
Reasons for Lags
Until recently, lags between money and
prices were commonly explained as reflections
of disequilibria in commodity and labor mar-
kets. According to this essentially Keynesian
approach, prices and quantities in a market
generally differ from their equilibrium values
as determined by the intersection of market
supply-and-demand schedules. In this view,
prices and quantities adjust gradually and
fairly mechanically toward their equilibria in
response to excess demand—the gap between
demand and supply at current prices. Money
32