Academic journal article Economic Inquiry

Do Prices Lead Money? A Reexamination of the Neutrality Hypothesis

Academic journal article Economic Inquiry

Do Prices Lead Money? A Reexamination of the Neutrality Hypothesis

Article excerpt

DO PRICES LEAD MONEY? A REEXAMINATION OF THE NEUTRALITY HYPOTHESIS

In one class of theoretical models, real effects occur only if

changes in money growth are expected to occur in some future

period, if expected in the current period, they are neutral. Some

empirical models examine the neutrality of expected current money

growth and therefore do not directly address the neutrality of

expected future growth. This paper develops an empirical model that

explicitly incorporates expected future changes in money growth.

A reexamination of the rationality, neutrality, and macro-rational

expectations hypotheses over a sample of four countries suggests

that the use of expected future money growth results in strong

rejections of the neutrality hypothesis.

I. INTRODUCTION

The revolution in macroeconomics inspired by the theory of rational expectations called into question the ability of systematic monetary policy to affect real economic variables. Much research has been devoted to the issue of policy effectiveness in the last decade and many examples have been constructed that demonstrate the theoretical possibility of nonneutrality even when expectations are formed rationally. One result of this research has been to demonstrate that the expectation of a future change in the money growth rate can cause a change in the current value of real output. In these models, an expected change in money growth at some point in the future results in a change in the price level in all time periods prior to the change in the money growth rate. This phenomenon of "prices leading money" see Brock [1974, 751] results in a change in real money balances in each time period prior to the expected change in the money growth rate, and the change in real money balances results in nonneutral changes in real output.

In order for the nonneutrality result to hold in this class of models, it is essential that the expected change in money growth be in some future time period so that prices, and hence real balances, change prior to the change in the money growth rate. When the change in money growth is expected to occur in the current time period rather than in the future, prices and the money supply change proportionately, leaving the value of real balances unchanged. In this case, there is no change in real output. This difference in the theoretical predictions concerning the neutrality of expected future and expected current changes in the money growth rate has implications for empirical tests of the neutrality hypothesis. According to these models, such tests ought to examine the significance of the relationship between the current value of real output and expected future changes in money growth. Tests of the neutrality hypothesis performed in the past, such as those by Barro [1977; 1978], Mishkin [1982; 1983], and Hoffman and Schlagenhauf [1982], have examined the significance of the empirical relationship between the current value of real output and the expected current money growth rate. Thus, these empirical models do not capture the crucial distinction between current and future changes in money growth rates. This paper develops an empirical model based on expected future rather than expected current changes in the money growth rate in the real output equation, and then reexamines the neutrality hypothesis.

The issue of whether expectations are formed rationally is also important in the analysis of the empirical evidence for the neutrality hypothesis. As Mishkin [1982; 1983] points out, the neutrality hypothesis has little meaning without a theory of expectation formation. In light of this, tests of the rationality hypothesis, as well as the joint hypothesis of rationality and neutrality known as the macro rational expectations hypothesis(1) (MRE), are also conducted.

II. THEORETICAL MODELS OF NONNEUTRAL MONEY

In many equilibrium rational expectations models, the neutrality of money depends upon whether an expected change in the money supply is in the current or some future time period. …

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