Expectations, money, and the forecasting of inflation

period as well as two sub-periods, 1961-70 and
1971-78 (Table 1). We used the “narrow” (M-
1) definition of money, partly because data for
the entire period were available only on that
basis.¹⁴ In deriving these estimates, we in-
cluded an additional variable —an average of
the current and eleven previous quarters’
growth in real balances—to help correct for
variations in the trend of real money demand
arising, for example, from financial innova-
tions. (A similar correction is used in the
Keran-Zeldes article in this Review). Also, to
help correct for the effects of oil-price in-
creases on real income growth, we included a
dummy variable for the period 1974-78.¹⁵

The choice of sub-periods reflects the differ-
ent international monetary arrangements in
force during those two periods. From 1961
through 1970, foreign countries’ monetary pol-
icies were constrained by the need to maintain
a fixed value of their currency in terms of the
dollar. Under the then-prevailing dollar stan-
dard, foreign inflation rates could not differ
from U.S. inflation rates over the long run.
After 1970, however, U.S. and foreign infla-
tion rates increasingly diverged, leading by
1973 to a complete breakdown of the fixed-
exchange-rate system. Thus monetary policies
abroad (at least) may now be less constrained
than they were in the earlier period, which
raises the question whether this shift is re-
flected in the money-inflation relation for these
countries. The crudeness of our estimates re-
flects the use of several simplifying assumptions.
In particular, we assume that non-money fac-
tors affecting inflation (not captured by the
money-demand correction) varied at a con-
stant average rate during the estimation pe-
riod, and that deviations from this rate were
unrelated to money growth.¹⁶ This and other
simplifying assumptions may account for some
of the anomalies of the results.

Our results suggest that the long-run impact
of money on prices frequently is significantly
different from unity. This might appear to con-
tradict the proposition of money neutrality,
which implies that an increase in money that
is sustained will eventually raise all prices in

Table 1
Relationship of Inflation and Money Growth 1961-78

NI: Not included (see note 6).

'Significantly different from unity at the 5% level.

²Significantly different from zero at the 5% level.

’Significantly different from zero at the 10% level.

’Indicates that the null hypothesis that all the slope coefficients are the same in the two periods can be rejected at (at
least) the 5% level.

⁵Defined as the average long-run growth of real balances over the current and previous 11 quarters.

⁶Included in the reported results only if its value was significantly different from zero at the 10% level; otherwise the
equation excludes the variable.

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