thus affects aggregate demand initially, with
prices responding only later and gradually to
the resulting excess demands in commodity
and labor markets. This adjustment process
was (at least implicitly) supposed to depend
upon institutional features of the market, and
not upon monetary policy or expectations
about it. However, economists have become
increasingly skeptical of this view, since it im-
plies that producers deliberately prolong a
state of excess demand even when they are
free to vary prices.7
More “modern” explanations of the money-
inflation lag suggest the potentially crucial na-
ture of individuals’ expectations about policy.
According to one argument, prices fail to re-
spond immediately and fully to money changes
because of an information lag between the
time a change in aggregate money occurs and
the time individuals find out about it. Under
this view, money changes that are perceived
by individuals are immediately and fully incor-
porated in prices, with no effect upon real out-
put; perceived money changes, that is, are
neutral even in the short-run. However, be-
cause of lags in the publication and dissemi-
nation of government statistics, individuals
generally do not know the level of the current
money stock, but must estimate its value based
upon their knowledge of current and past eco-
nomic conditions. When their estimates are
“incorrect,” actual aggregate demand will dif-
fer from the level perceived by consumers and
firms. For example, when money rises by more
than is anticipated, a typical firm experiences
an increase in demand for its product that is
apparently greater than the increase it per-
ceives in aggregate demand. Consequently,
firms generally raise real output in response.
But because of the adjustment costs involved
in varying output and employment levels,
firms usually will need a considerable amount
of time to return to their original levels of
output, even after they find out the true level
of the money stock. These output changes in
turn may account for the protracted response
of observed money-price effects.8
Another explanation of the delay in the
monetary impact emphasizes lags in the re-
sponse of aggregate demand itself. Specifically,
individuals may shift their demands more in
response to changes in money that are viewed
as persistent than to transient changes. This
suggests that aggregate demand will vary pro-
portionately with the average of current and
past money growth— the best reflection of per-
manent money changes—rather than only to
changes in the current money stock. Further-
more, aggregate demand may be influenced by
interest rates, which respond to expectations
of future inflation. This means that current ag-
gregate demand will depend upon expectations
of future money growth—the likely basis of
expectations of future inflation—and thus indi-
rectly upon observed current and past money
changes (to the extent they indicate future
money changes).’ In either case, there may be
a lag between money and prices, even when
prices respond immediately and fully to cur-
rent aggregate demand.
Neither of these explanations involves any
impediments to the adjustment of prices to
aggregate demand. In practice, however, such
impediments almost surely exist. In some in-
dustries, for example, prices and wages are set
for protracted periods by contracts which con-
tain only limited indexing provisions. In many
activities, furthermore, prices are constrained
by implicit agreements that limit the frequency
of price changes. For example, when a de-
partment-store chain mails out a catalogue it
makes a tacit agreement to honor the listed
prices—even when it is not legally bound to
do so. Why do firms voluntarily limit their
price responsiveness to current demand con-
ditions? One important motivation may be the
customer loyalty that firms gain by offering a
more stable and predictable price than they
would offer if they responded to every shift in
demand.10 In any case, firms that set fixed
prices over a certain period are likely to fore-
cast the level of demand for that period, which
means that they will (at least implicitly) make
judgments about future levels of the money
stock.
33