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Expectations and Inflation Prediction
All except the first of our explanations of
the money-price lag imply that current prices
depend, directly or indirectly, upon firms’ and
individuals’ forecasts of money over some
(generally considerable) future interval. This
is perhaps most obvious when prices are fixed
by explicit or implicit contracts, because price
setters then will have to assess the probable
level of demand prevailing over the contract
life. But producers’ judgments about the di-
vision of current money into transient or per-
manent components also involve predictions
about future money. Furthermore, producers’
strategies about changes in future output lev-
els, in the interval before prices respond fully
to money, are likely to depend upon their pro-
jections of future money. “
The implications of this money-price rela-
tion for predictions of inflation depend crucially
upon how the forecasts of future money are
made. Let us assume that predictions of future
money are based entirely upon past observa-
tions of money growth. Then, the above anal-
ysis suggests, the timing of money’s effect
upon prices depends upon two sets of factors:
a) Rigidities and imperfections that are largely
determined by institutional structures, prece-
dent or law, and/or technical factors that are
largely unaffected by all but drastic changes in
expectations and policy. (Examples are con-
tracts, costs of adjusting output and employ-
ment, and factors generating incomplete infor-
mation about conditions relevant to individuals’
decisions); and b) The relation used by indi-
viduals to forecast future money, in particular
the relation they perceive between already ob-
served money changes and those they antici-
pate in the future.
It follows that money-price relations, such
as (1), are likely to remain unaffected by mon-
etary-policy changes only if individuals do not
change the way they forecast future money.
But this is unlikely to be the case in the event
of major policy changes; however crude their
forecasting techniques, individuals are likely
to adapt their forecasts eventually to changing
conditions.12
Also, according to this view, information on
variables that do not directly affect prices but
which aid individuals in predicting money
should be useful in predicting current as well
as future inflation. Sunspot activity is unlikely
of itself to affect aggregate prices—but if sun-
spots are useful in predicting future money,
analysts must take them into account in as-
sessing current and future inflation develop-
ments. In other words, knowledge of the fac-
tors that directly cause price changes is only a
partial guide to their prediction.13
Some Evidence
Analysts normally develop inflation forecasts
from relations similar to (1) without explicitly
accounting for individuals’ expectations. Fre-
quently they estimate the forecasting relation
on the basis of data for all or most of the post-
World War II period; the result then reflects
some “average” of the monetary policies pre-
vailing over the entire period. But as our anal-
ysis suggests, this procedure may lead to seri-
ously biased inflation forecasts if monetary
policy has changed substantially and if individ-
uals’ expectations have changed to reflect this
fact. The appropriate relation for forecasting
inflation may be unstable, that is, may vary over
time.
How important a practical problem this pre-
sents is an empirical question. The lag between
money and inflation may primarily reflect insti-
tutional factors and adjustment costs, rather
than expectations, in which case the lag should
not vary perceptibly with policy. Alternatively,
policies themselves may not vary substantially
over time; or expectations about policy may
change only very gradually. If any of these
statements are true, relations such as (1) may
not be very different now from what they were
twenty years ago.
A direct, although crude, way to measure
the role of expectations is to see how money-
inflation relations vary from period to period.
This we have done with the relation between
quarterly consumer-price changes and current
and past money growth for several industrial
countries, including the U.S., for the 1961-78
34