1
Expectations and the Neutrality of Money
1. Introduction*
This paper provides a simple example of an economy in which equilibrium prices and quantities exhibit what may be the central feature of the modern business cycle: a systematic relation between the rate of change in nominal prices and the level of real output. The relationship, essentially a variant of the well-known Phillips curve, is derived within a framework from which all forms of âmoney illusionâ are rigorously excluded: all prices are market clearing, all agents behave optimally in light of their objectives and expectations, and expectations are formed optimally (in a sense to be made precise below).
Exchange in the economy studied takes place in two physically separated markets. The allocation of traders across markets in each period is in part stochastic, introducing fluctuations in relative prices between the two markets. A second source of disturbance arises from stochastic changes in the quantity of money, which in itself introduces fluctuations in the nominal price level (the average rate of exchange between money and goods). Information on the current state of these real and monetary disturbances is transmitted to agents only through prices in the market where each agent happens to be. In the particular framework presented below, prices convey this information only imperfectly, forcing agents to hedge on whether a particular price movement results from a relative demand shift or a nominal (monetary) one. This hedging behavior results in a nonneutrality of money, or broadly speaking a Phillips curve, similar in nature to that which we observe in reality. At the same time, classical results on the long-run neutrality of money, or independence of real and nominal magnitudes, continue to hold.
These features of aggregate economic behavior, derived below within a particular, abstract framework, bear more than a surface resemblance to many of the characteristics attributed to the U.S. economy by Friedman [3 and elsewhere]. This paper provides an explicitly elaborated example, to my knowledge the first, of an economy in which some of these propositions can be formulated rigorously and shown to be valid.
A second, in many respects closer, forerunner of the approach taken here is provided by Phelps. Phelps [8] foresees a new inflation and employment theory in which Phillips curves are obtained within a framework which is neoclassical except for âthe removal of the postulate that all transactions are made under complete information.â This is precisely what is attempted here.
The substantive results developed below are based on a concept of equilibrium which is, I believe, new (although closely related to the principles underlying dynamic programming) and which may be of independent interest. In this paper, equilibrium prices and quantities will be characterized mathematically as functions defined on the space of possible states of the economy, which are in turn characterized as finite dimensional vectors. This characterization permits a treatment of the relation of information to expectations which is in some ways much more satisfactory than is possible with conventional adaptive expectations hypotheses.
The physical structure of the model economy to be studied is set out in the following section. Section 3 deals with preference and demand functions; and in section 4, an exact definition of equilibrium is provided and motivated. The characteristics of this equilibrium are obtained in section 5, with certain existence and uniqueness arguments deferred to the appendix. The paper concludes with the discussion of some of the implications of the theory, in sections 6, 7, and 8.
2. The Structure of the Economy
In order to exhibit the phenomena described in the introduction, we shall utilize an abstract model economy, due in many of its essentials to Samuelson [10].1 Each period, N identical individuals are born, each of whom lives for two periods (the current one and the next). In each period, then, there is a constan...