RDP 1978-01: Two Essays in Monetary Economics 4. Price Effects

Considerable controversy surrounds the appropriate specification of price and balance of payments effects of domestic stabilisation policies. With well established links between domestic policy and output, and between output and the balance of payments,^[1] a link from money to the balance of payments is established. There are two popular models in which the price effects are assumed away; the Keynesian fix-price model^[2] and the purchasing power parity model in which (with fixed exchange rates) domestic prices are set by world prices in the small open economy, even in the short run. Conversely, the rational expectations model of the closed economy predicts that output will remain at its equilibrium level (or rate of growth) except for random fluctuations, in the face of changing money supply; economic agents will, it is argued, inevitably recognise the implications of a change in the money stock and adjust prices accordingly.

Most economists would probably reject both of the fix-price models, and the closed economy rational expectations model in which an increase in money immediately increases prices. This rejection is based on the importance of domestic demand pressure on price adjustment in a frictional world, and the following extracts from Hume's essay “Of Money” represent a view that would probably be widely accepted:

“… in every Kingdom, into which money begins to flow in greater abundance than formerly, everything takes a new face: labour and industry gain life; the merchant becomes more enterprising, the manufacturer more diligent and skillful, and even the farmer follows his plough with greater alacrity and attention”.^[3]

“…the alterations in the quantity of money, either on one side or the other, are not immediately attended with proportional; alteration in the price of commodities. There is always an interval before matters can be adjusted to their new situation; and this interval is as pernicious to industry, when gold and silver are diminishing, as it is advantageous when these metals are increasing.”^[1]

As the discussion makes clear, Hume invokes distributional effects, and recognition and information lags to explain why changes in money first change output, and recognises that changing output is taken as a signal that prices can be raised. This surprisingly modern view is echoed in the theoretical analysis of Arrow (1959) and others, and in the findings of American and British empirical work on inflation surveyed, for example, by Laidler and Parkin (1975). As this survey indicates, there is wide agreement that there is no long-run trade-off between inflation and unemployment.

It would be wrong to claim, however, that there is wide agreement on the relative importance of exogenous wage changes, direct world price effects on domestic wage and price determination, direct monetary effects on prices and wages, and about the most appropriate specification of the effects of demand pressures in goods and labour markets. The controversy in these areas arises for two reasons. The first is that the details of expectations generating processes differ from country to country, according to local institutional details, such as the framework for wage setting,^[2] and the different economic, policy rules used by different governments. The second reason for controversy is even more fundamental, and relates to the issues raised in the analysis of rational expectations. As noted, this analysis predicts that expectations will depend on the policy rules which are followed, and policy rules change over time – exchange rates may become more flexible, for example, and this is likely to lead economic agents to place a heavier weight on domestic monetary conditions relative to world prices in forming price expectations. In the RBA76 model of the Australian economy, for example, the excess demand for money is included in the price and wage equations. This measure of disequilibrium in the money market is assumed to capture price expectation effects, and there is evidence that these have increased in importance as recent observations including the period of more flexible exchange rates are added to the sample period.^[1]

This whole area is developing rapidly and it is therefore difficult to generalise about the details of the adjustment mechanisms for wages and prices.^[2] For this writer, two general conclusions stand out. The first is that under a wide variety of conditions the lag from changes in the exchange rate or in world prices to changes in domestic prices needs to be measured in years rather than months.^[3] This implies that the instantaneous price arbitrage model favoured by some economists cannot be directly relevant for policy analysis. The second conclusion is that excess money is likely to have a direct effect on price and wage adjustment, although this effect is not as strong as suggested by some analyses of rational expectations. A direct effect of monetary disequilibrium on prices, as distinct from indirect effects working through demand pressure in goods and labour markets, means that a monetary disturbance is likely to include contemporaneous price and output fluctuations in both closed and open economies. In the open economy case, changes in prices in the rest of the world will influence domestic prices through a variety of channels, setting up disequilibria in all markets which generally appear to be eliminated only after a relatively lengthy adjustment period. Similarly, any domestic onetary disturbance will be followed by domestic price and output responses which have indirect effects on the balance of payments which work to eliminate the original monetary disequilibrium.

Footnotes

As in the most basic Keynesian open economy model. [1]

It is often specified with exogenous money wages and prices determined as a constant mark-up on unit labour costs, although in some versions exogenous import prices are also recognised. [2]

Rotwein (1955), p.37. [3]

Rotwein (1955), p.40. [1]

For example, in Australia the role of the centralised wage setting tribunals must be taken into account in an analysis of the dynamics of inflation. [2]

Conversley, a direct world price effect in the domestic price equation is zero in the period since the move to more flexible exchange rates. This evidence is extremely weak, however, and there is need for considerable research in this area. [1]

Indeed, as argued by Laidler (1977), p.52, there may. be no unique structure inside the famous “black box”. [2]

See Cross and Laidler (1976) for a multicountry study of this issue, Jonson (1976) and Ball, Burns and Laury (1976) for the U.K. and Jonson, Moses and Wymer (1976) for Australia. [3]