EFFICIENT INFORMATION PROCESSING IN OUTPUT MARKETS: TESTS AND IMPLICATIONS

If goods markets efficiently process information, much of received macro doctrine seems of little relevance. Neither unemployment nor the money stock should be leading indicators of inflation. Countercyclical monetary policy will have little effect on inflation. Restrictive monetary policy can have severe effects on real variables if the public is unconvinced the authorities are committed to reducing inflation. When proper account is taken of mean shifts in the stochastic process generating CPI inflation rates, there is little remaining autocorrelation indicative of inefficiency, and filter rule experiments similarly support the hypothesis of goods market efficiency.     

INFLATION, HEDGING AND THE DEMAND FOR MONEY: SOME EMPIRICAL EVIDENCE

This paper explores the role of nominal rate of return uncertainty and inflation hedging as potentially important factors explaining the pattern of money demand. Using U.S. quarterly data over the period 1952.2–1982.4, it is shown that in conformity with theoretical considerations the nominal rate of return uncertainty variable tends to have a significantly positive effect and the inflation hedging variable (the covariance between nominal rate of return and inflation rate) a significantly negative effect on the demand for money. These findings seem to be reasonably robust in terms of various definitions of income, interest rates, inflation rate and money variables as well as in terms of different estimation methods.     

THE SWINGS OF U.S. INFLATION AND THE GIBSON PARADOX

In recent business cycles, U.S. inflation has experienced a reduction of volatility and a severe weakening in the correlation to the nominal interest rate (Gibson paradox). We examine these facts in an estimated dynamic stochastic general equilibrium model with money. Our findings point at a flatter New Keynesian Phillips Curve (higher price stickiness) and a lower persistence of markup shocks as the main explanatory factors. In addition, a higher interest‐rate elasticity of money demand, an increasing role of demand‐side shocks, and a less systematic behavior of Fed's monetary policy also account for the recent patterns of U.S. inflation dynamics. (JEL E32, E47)     

SOME REAL EVIDENCE ON THE REAL BILLS DOCTRINE VERSUS THE QUANTITY THEORY

Researchers interested in testing between the Real Bills doctrine and the Quantity Theory approach to inflation in the face of rapid, deficit-financing money growth are confronted by an observation equivalence problem. This paper identifies a data set which resolves the dilemma and tests the two inflation models. The results provide clear evidence supporting the Real Bills doctrine, that the value of assets backing money determines its value, over the Quantity Theory.     

THE LONG-RUN LINK BETWEEN MONEY GROWTH AND INFLATION

Is inflation always a monetary phenomenon? Many economists believe that the link between money growth and inflation in the U.S. has weakened over the last two decades due in part to the Federal Reserve's policy experiment in 1979–1982 and innovations in the financial sector of the economy. I find that the long-run relationship between money growth and inflation is strong in a statistical sense and important economically. The key result is that the trend or growth component in CPI inflation is entirely due to the trend component of monetary base growth. (JEL C32, E31, E51)     

A RESPECIFIED TAX-ADJUSTED FISHER RELATION

How much will a 1% increase in expected inflation increase nominal interest rates? Irving Fisher's famous equation implies that nominal interest rates will rise in proportion to an increase in expected inflation. Darby and Feldstein, correcting the Fisher equation for taxation, predict a nominal interest rate increase of [1/(1 - T)]% where T is the marginal tax rate: i.e., if T =3, then a 1 % increase in expected inflation should cause a 1.4 % rise in interest rates. Empirical evidence, however, suggests that the rise in interest rates is much smaller than the Darby/Feldstein prediction. Estimates are around 9, varying mostly between 5 and 1.15, which is much closer to Fisher's original prediction. It is important to know the size of the interest rate response to inflation expectations in a world in which inflation and interest rates are volatile and in which tax laws are designed to influence savings and investment through interest rates. In this paper we attempt to close the gap between theorized and estimated effects of inflation by incorporating into the Fisher equation two important aspects of the U.S. tax code: historic cost depreciation and the lower tax rate on capital gains. Our model shows that the effect of expected inflation on interest rates is dampened by the lower benefits from depreciation deductions arid the capital gains tax. Our corrected Fisher equation predicts a 1.12 % nominal interest rate increase, rather than the 1.4 % increase implied by the Darby/Feldstein model. The, our model closes about 56 % of the gap between theory and empirical evidence. The remainder could be closed by additional refinements in the model or better empirical modeling.     

UNCERTAIN EFFECTS OF MONEY AND THE LINK BETWEEN THE INFLATION RATE AND INFLATION UNCERTAINTY

In the postwar period high rates of inflation are associated with high levels of inflation uncertainty. In this paper I argue that the inflation rate and inflation uncertainty are linked by forecasters' uncertainty about the impact of money growth on the price level, and I present evidence indicating that this has been the case. As long as the impact of money growth on the price level remains unpredictable, then even predictable money growth will cause inflation uncertainty with its accompanying adverse effects on employment and output.     

THE EFFECT OF FISCAL POLICY ON THE SHORT-RUN RELATION BETWEEN NOMINAL INTEREST RATES AND INFLATION

This paper presents a simple empirical model of the relation between the inflation rate and the nominal interest rate. We show that previous results found in the literature may be attributed to specification error and that there are natural explanations for the observed signs of previous Fisher equation estimates. Our results show that fiscal policy shocks may generate short run negative correlations between changes in inflation and changes in the nominal interest rates. These results illustrate the difficulty in discussing the relation between inflation and nominal interest rates without conditioning the analysis with specific assumptions on the course of the economy.     

INTERNATIONAL PRICE BEHAVIOR AND THE DEMAND FOR MONEY

Oil prices, commodity prices and American monetary policy, the last operating through a variety of channels, have all figured prominently in explanations of the international inflation process in the late 1960s and early 70s. OUT major purpose in this paper is to test these various hypotheses. We do so in the context of a reduced-form rational-expectations price equation which we estimate for the United States and seven other industrial countries using quarterly data for the period 1955 through 1976.
The principal conclusion that emerges from this exercise is that movements in domestic money in these countries served as the key link in the inflation process. The factors that produced these monetary changes, however, differed among countries. Price shocks of various sorts were clearly of secondary importance.
The other important set of conclusions concerns the demand for money. In place of a traditional stock adjustment model, we used GLS with a second-order correction for autocorrelation. We believe this produced more plausible estimates of the parameters of the long-run demand function and of the adjustment process itself.     

ALTERNATIVE P* MODELS OF INFLATION FORECASTS

This paper reevaluates the inflation forecast performance of M2-based P* models relative to other competing models over the period of 1970–96. Included in the comparative study are newly developed monetary aggregates, including M2+, MZM, and M2*, and direct treatments of velocity changes associated with recent developments in M2. Out-of-sample rolling-horizon forecast exercises suggest that the predictive accuracy of alternative P* model specifications relative to traditional inflation models is not robust to different subsamples. The switching forecast performance between money-based and output-based models across periods highlights the extent of structural instability in the inflation generating process. (JEL E3, E4, C2)     

EXCHANGE RATE VOLATILITY: THE ROLE OF REAL SHOCKS AND THE VELOCITY OF MONEY

The effects of stochastic output shocks on the behavior of ex-change rates and nominal price levels is studied within the context of a two-country, cash-in-advance model. The analysis of this model, in contrast to the existing cash-in-advance literature, demonstrates that exchange rates can be more volatile than price levels even though agents' elasticity of substitution between foreign and domestic goods is greater than one-half. This possibility arises when output shocks are autocorrelated and are due to revisions in expectations that affect the terms of trade and/or the velocity of money.     

A MARKET-BASED TEST OF THE EFFECT OF MONETARY POLICY

This paper tests the rational expectations-natural rate hypothesis without basing expectations on time series estimates. Instead, market-based data are used. Unexpected money supply changes are determined via the Fisher Effect and the Quantity Equation. This introduces errors of a very different kind than the traditional approach, and yet the results are remarkably similar to those generated using time series estimates. Unanticipated money shocks are shown to exert a significant but only short-run effect on real output, suggesting only a short-run Phillips curve trade-off. Anticipated money growth appears to have no effect on real output.     

ANTICIPATED INFLATION AND AGGREGATE EMPLOYMENT: THE CASE OF COSTLY PRICE ADJUSTMENT

Even if inflation is perfectly anticipated, a firm that finds nominal price adjustments sufficiently costly will reset its price at multi-period intervals. Consequently, its average output will change in a direction that depends on properties of its profit function. On the basis of this observation, which does not involve money illusion, the paper shows that anticipated inflation can stimulate aggregate employment through a process that entails changes in the factor demands of individual monopolistic firms and in the intersectoral allocation of consumer expenditure. Simulations indicate, however, that the gain in aggregate employment is likely to be modest.     

UNCERTAINTY IN THE DEMAND FOR MONEY DURING HYPERINFLATION

Much recent empirical work on hyperinflation has centered on the direct and indirect effects of uncertainty on the demand for money. We test the hypothesis, originally put forward by Klein, that uncertainty positively affects the demand for real balances. A variant of Cagan's demand for money function is utilized and operational measures of uncertainty are derived by fitting autoregressive integrated moving average models to the inflation series for each of three hyperinflation nations. We find that the most reasonable measures of variation do not significantly enter the money demand function for any of the three hyperinflations studied.     

PREDICTING INFLATION: DOES THE QUANTITY THEORY HELP?

Various inflation forecasting models are compared for the period 1979–2003 using a simulated out-of-sample forecasting framework. Our findings are (1) M2 has marginal predictive content for inflation; (2) it is necessary to allow for the possibility that money, prices, and output are cointegrated; and (3) cointegration vector parameter estimation error is important when making out-of-sample forecasts. Consistent with previous work, we find a structural break in the early 1990s, but the break was easily detected and would not have affected out-of-sample inflation forecasts. Two Monte Carlo experiments that lend credence to our findings are also reported on.(JEL E31 , C32 )     

MONEY,OUTPUT, AND INFLATION IN THE LONGER TERM: MAJOR INDUSTRIAL COUNTRIES, 1880–2001

We study how fluctuations in money growth correlate with fluctuations in real output growth and inflation. Using band‐pass filters, we extract cycles from each time series that last 2–8 (business cycles) and 8–40 (longer‐term cycles) years. We employ annual data, 1880–2001 without gaps, for 11 industrial countries. Fluctuations in money growth do not play a systematic role at business cycle frequencies. However, money growth leads or affects contemporaneously inflation, but not real output growth, in the longer run. Also, formal break tests indicate no structural changes for the longer‐term money growth and inflation relationship, despite changes in policy regimes.(JEL E3)     

Money illusion,financial literacy and numeracy: Experimental evidence

Money illusion is usually defined as the inability of individuals to correctly account for inflation or deflation when making decisions. Empirical evidence shows that money illusion matters in financial decisions, particularly those made by households. In this article, we analyze money illusion at the individual level within the context of financial choices and study its relationship with numeracy and financial literacy. To do so, we propose an original measure of money illusion via an experimental task. This task consists of a series of choices between a pair of simple bonds whose returns are affected only by inflation (or deflation). We provide a fine-grained measure of money illusion that is correlated with typical measures (questionnaires) of it. Moreover, we show that money illusion depends on the choice context (e.g., inflation or deflation) and participants’ abilities. Individuals with financial knowledge are less sensitive to money illusion than others, while there is no evidence of an impact of numeracy.     

A NOTE ON THE VANISHING LIQUIDITY EFFECT OF MONEY ON INTEREST

This paper provides a brief review and critique of some of the results and conclusions of Melvin [1983] concerning the effects of inflation on the response pattern of interest rates to changes in money growth rates. It also presents results concerning the significance of two different measures of the inflationary environment ––– the actual rate of inflation and the variance of the inflation rate ––– in explaining this response. The conclusion drawn here is that the variance of the inflation rate better explains the changing money-interest relationship. This conclusion is rather different from that of Melvin.     

INFLATION AND GOVERNMENT DEFICITS

There is a pronounced positive correlation of inflation and government deficits in the United States since World War II. The purpose of this paper is to test the three leading explanations of this correlation. These three explanations are: (a) a deficit increases prices through a wealth effect; (b) a deficit results in the Federal Reserve purchasing debt, thus increasing the money supply and prices; and (c) expected inflation increases the deficit (which is the change in the nominal value of bonds). No support is found for either of the first two hypotheses. The results indicate that expected government deficits have no significance for future inflation.     

INFORMATION RIGIDITIES,INFLATION PERCEPTIONS,AND THE MEDIA: LESSONS FROM THE EURO CASH CHANGEOVER

The objective of theoretical models of information rigidities is to capture the fact that people are constrained in their ability to acquire and process all available information. Given that most people obtain their information about the economy from the media, press coverage of the economy may exert an influence on peoples' attitudes. This paper tests for this influence by examining consumers' inflation perceptions in the aftermath of the euro cash changeover, which serves as a natural experiment. Using a new data set, that quantifies the intensity and tone of media reports, we document that media reporting has had a statistically significant and economically meaningful impact on inflation perceptions and contributed to their sharp rise in the aftermath of the euro cash changeover and to the divergence between inflation perceptions and actual inflation rates. (JEL E53, D83)