must fix its price by contract for several pe-
riods. The demand for the firm’s product over
the life of the contract may be primarily de-
termined by the level of aggregate demand
which (to simplify matters) we may assume
varies proportionately with the money stock.
Now if the firm sets too high a price relative
to expected demand, it will be unable to sell
all it produces and thus must carry inventories
at some cost; if it sets too low a price, it will
have to delay deliveries, speed up production
schedules, and/or draw down inventories from
desired levels, all of which entail additional
costs. Hence the firm may try to set an average
price that would ensure that sales equal output
over the contract period.18 This average will
then depend upon the expected level of aggre-
gate demand over the contract period, so that
in setting its price the firm must forecast some
average of the money stock over its planning
horizon. Alternatively, suppose that all prices
vary simultaneously with aggregate demand,
but that (nominal) demand depends upon in-
dividuals’ expected “permanent” level of
money—that is, upon an average of the money
balances they expect to have now and in the
future. It should be clear, at least intuitively,
that prices again will depend upon an average
of money levels expected in the future. (The
appendix demonstrates this point, and also
demonstrates that the dependence of aggre-
gate demand upon interest rates is likely to
lead to a similar conclusion).
Suppose then that prices in industry “i” vary
proportionately with an average of the level of
money expected now and in the future. This
average (permanent money) can be written
without any essential loss of generality as,
m*-t- = n+I tm<t) + ,mc(t+l) +
tme(t+l) + . . . tmc(t + n)] (2)
where m4(t) is the logarithm of permanent
money, m(t) is the log of the current aggregate
money stock, and tme(t + j) is the log of money
currently (at t) anticipated j periods in the
future. In other words, m*(t) is individuals’
current anticipation of the average level of
money over their future planning horizon. 19
It follows that prices in industry “i” will vary
proportionately with permanent money, or,
pi(t) = m*(t) (3)
where ρi(t) is the log of industry i’s price. (To
simplify the discussion, we may neglect all
other factors affecting the demand for and sup-
ply of firm products.)20 Since the aggregate
price level is simply an average of industry
prices, it too will vary proportionately with
permanent money; more precisely, if all antic-
ipated future money stocks rise by a given
proportion, the aggregate price level will even-
tually increase by that proportion. However,
when prices are set by contracts, the response
of the aggregate price level to a change in
permanent money is likely to be substantially
slower than that for an individual industry. In
a contract situation, some prices composing
the current aggregate price index, having been
set earlier, will be based upon past permanent
money; thus the aggregate price level will re-
spond to an average of current and past per-
manent-money levels.21
The pricing strategy outlined above tends to
diminish the impact of perceived transient
money changes on inflation. That is, monetary
variations which individuals view as transient
have little or no effect upon their estimates of
permanent money, and thus little effect upon
prices. In principle, this general strategy is sen-
sible whatever policy is followed by the mon-
etary authorities. Of course, the exact relation
between aggregate prices and permanent
money depends upon firms’ forecasting hori-
zons, which influences their calculation of per-
manent money, and depends also upon con-
tract durations and the timing of renewals—all
of which could be affected by monetary-policy
decisions. However, these characteristics are
based upon industrial-organization patterns
and other institutional features that generally
change slowly and that generally remain un-
affected by all but the most dramatic policy
shifts. Thus, at least upon examination we may
view relation (2) as invariant to expectations
about policy.
37