Inflation, Stagflation, Relative Prices, and Imperfect Informationby Alex Cukierman

Inflation, Stagflation, Relative Prices, and Imperfect Information by Alex CukiermanReview by: Steve ThomasThe Canadian Journal of Economics / Revue canadienne d'Economique, Vol. 20, No. 2 (May,1987), pp. 423-427Published by: Wiley on behalf of the Canadian Economics AssociationStable URL: http://www.jstor.org/stable/135377 .

Accessed: 13/06/2014 23:15

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

Wiley and Canadian Economics Association are collaborating with JSTOR to digitize, preserve and extendaccess to The Canadian Journal of Economics / Revue canadienne d'Economique.

http://www.jstor.org

This content downloaded from 62.122.79.90 on Fri, 13 Jun 2014 23:15:53 PMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=black

http://www.jstor.org/action/showPublisher?publisherCode=cea

http://www.jstor.org/stable/135377?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


Reviews of books Comptes rendus 423

of concern to labour economists, and - in particular - the incentive effects of employer-sponsored pension plans.

JAMES E. PESANDO University of Toronto

Inflation', Stagflation, Relative Prices, and Imperfect Information by Alex Cukierman. New York: Cambridge University Press, 1984. Pp. xiii + 202. Index. ISBN 0-251-25630-5

This book is about the imperfect information approach to macro-modelling, to which Cukierman, along with various co-authors, has contributed extensively in the recent past. Two types of information imperfections are considered: the first part of the book deals with models in which individuals have asymmetric information about the current general price level, and hence suffer from aggregate-relative confusion. The emphasis here is on the relations between monetary variability, the Phillips curve trade-off, the distribution of inflationary expectations, inflation uncertainty, and relative price variability. The second part examines models in which individuals cannot distinguish permanent from transitory shocks, neither instantaneously nor after a delay, thus creating confusion between permanent and transitory changes. The implications of such confusion for stagflation, the efficiency of the price system, relative price variability, and inflation are developed. The material is clearly presented: the models are built up logically and the longer mathemati- cal proofs relegated to appendixes at the end of the relevant chapter. Each chapter is accompanied by notes and a glossary of symbols.

The book begins with a general overview of the issues present when economists began to think through the implications of imperfect information for macro-economics: the temporary nature of the Phillips curve trade-off, the rejection of adaptive in favour of rational expectations, and the associated irrelevance of systematic monetary policy. However, if the Phillips curve did provide a permanent trade-off and if relative prices were related to overall inflation (as had been noted for many years), then the classical dichotomy between real and nominal magnitudes would be under threat. Beginning with the seminal contribution of Lucas (1973), models involving aggregate/relative confusion and later permanent/transitory confusion were developed to explain these phenomena within an equilibrium framework.

Chapter 2 introduces the idea that individuals do not have perfect current information about the general price level: although they have full information on prices in their own markets, they cannot distinguish precisely between price changes that are caused by adjustments in the general price level and those that reflect changes in relative prices. This notion of asymmetric information has been used extensively in the micro-economic and finance literature, and a fairly substantial review is offered as a prelude to the main story.



424

The basic model incorporating this aggregate/relative confusion is then developed in chapter 3, beginning with a full current information version of the Lucas (1973) model, where relative prices depend only on real relative shocks to demand, not on the quantity of money. If information about the current general price level is now assumed to be available with a one-period lag, then agents have to form forecasts, and hence the possibility for aggregate/relative confusion is reintroduced into the Lucas model. Cukierman then demonstrates how the expectations formed by making optimal use of the information available in each market, together with knowledge of the structure of the economy, yields a rational expectations equilibrium. The implications of this for the short-run Phillips curve is then investigated together with a brief review of Lucas's evidence. The author is careful to stress the intuition behind the results presented.

A number of extensions are presented in the next three chapters. In chapter 4 we see that if agents have different information in different markets, then heterogeneous aggregate price expectations will be formed, and this is substantiated by appealing to survey evidence. It is shown how, within this model, an increase in the variance of monetary expansion increases the cross-sectional variance of inflationary expectations and the variance of inflation itself. If a serious social cost of inflation is brought about by its unpredictability, and this is related to its variability, then this is an important point. However, inflation uncertainty and variability are ndt necessarily closely related (see Engle (1983) ).

Chapter 5 takes as its point of departure the previously noted heterogeneity of inflation expectations and its implication for perceived real rates of interest and the bond market. Fisher's theory of interest is generalized to allow for differential inflationary expectations, and the allocative efficiency of the bond market is investigated under such conditions. When the real rate of interest perceived by different traders varies, basic conditions of welfare economics are violated; welfare losses increase as inflation uncertainty, the variance of inflationary expectations, and the variance of inflation itself rises. Not surprisingly, changes in the distribution of inflationary expectations lead to increased bond trades as traders review their positions. Chapter 6 develops the link between the variability of relative prices and inflation, a topic which has received substantial empirical interest of late. Thus far the 'islands' market- clearing model has had constant supply elasticities across markets, and no major conclusions have been lost as a result: at this point differing supply elasticities are introduced, and these interact with the aggregate/relative confusion to induce relative price variability. To conclude the first part of the book a centralized bond market is introduced that can, if there is only one aggregate shock, reveal the current general price level to individuals in all markets. However, if there is more than one aggregate shock, we would need more centralized asset markets, so the signal extraction problem would remain.




The second half of the book develops the idea that agents are continuously subject to confusion between permanent and transitory developments: in particular, and in contrast to aggregate/relative confusion, the former confusion does not disappear when the current values of all economic variables are known by everyone. This approach is particularly appealing for examination of the labour market, since it offers a way of reconciling a sluggish adjustment of real wages and the persistence of unemployment with market-clearing and rational expectations present. To put matters in perspec- tive, chapter 8 contains a brief overview of alternative explanations of such persistence, including capital adjustment costs, inventory changes, and staggered contracts. In chapter 9 an extended IS-LM model is constructed with labour supply depending on both the current and permanent perceived wage rates. Productivity, aggregate demand, labour supply, money demand, and money supply all are subject to random shocks, which comprise both transitory and permanent components. Optimal predictions for the permanent values of the endogenous variables are generated using current and past values of the variables: agents cannot observe the permanent and transitory components of shocks separately, though as new information becomes available, the informational limitation gradually disappears. The responses of the endogenous variables to productivity, monetary, and aggregate demand shocks are examined. Stagflation can arise even in a neoclassical framework when there is uncertainty about the permanence of shocks: suppose a large permanent decrease in productivity is observed, but people cannot tell if it is permanent or transitory. Then workers may refuse work at what they believe to be temporarily lower real wages, but such beliefs are revised as time passes.

In chapter 10 Cukierman reverts to a multimarket model to see how erratic monetary policy and uncertain shifts in the relative supplies and demands can lead to confusion between permanent and transitory changes in relative prices. The larger the variance of differential monetary noise, the lower is the allocative efficiency of the price system: if this variance and the rate of monetary growth are positively related, then there is clearly an argument for reducing monetary growth. Finally, in chapter 11 the implications of permanent-transitory confusion for relative price variability and inflation are examined using a model similar to chapter 10. The previous chapter revealed how producers may get confused in this world, and this same confusion leads to relative price variability as supply responses and hence price changes vary across sectors. The implications for the rate of inflation and the cross-sectional relation between the variance of inflation and the variance of relative pnrce changes are then derved.

The book is notable for its clarity of content and purpose and as such can be recommended to graduate students and others seeking a clear and concise introduction to the imperfect information approach to macro-modelling. However, there is a lack of critical insight when these models are confronted with empirical evidence, though the author recognizes that such confrontations



426

are essential to the development of the subject. For example, there is widespread evidence that relative price changes do not follow the normal distribution (e.g., Buck and Gahlen, 1983), yet this is an important maintained hypothesis of the aggregate-relative confusion section which is left unchal- lenged. These simple frameworks have, to my knowledge, never yielded data-consistent models, though their value as pedagogic devices is not in doubt. Rather, authors express satisfaction with 'correctly' signed coefficients despite the evidence of substantial misspecification (e.g., Hercowitz, 1981). Mizon, Safford, and Thomas (1985) have extended the simple 'money surprise-islands' model to include additional macro variables and indirect tax changes within the framework suggested by Pagan, Hall, and Trivedi (1983). This clearly leads to a markedly better empirical performance on UK data, and in particular emphasizes the role of fiscal variables when the relative price variability and inflation relationship are examined. Similar evidence was found by Thomas and Weldon (1986) using Canadian data. It would thus appear that the models presented in Cukierman's text are overly simple as they stand for explaining real world phenomena, in particular with their emphasis on monetary surprises and variability; however, their relevance may be redeemed by sensible extensions. It is a pity that the current text does not refer in detail to the work of Engle (1983) and Pagan, Hall, and Trivedi (1983) which offer additional empirical insight into the phenomena under investigation. Further, suitable econometric tools are now available for the estimation of 'surprise' and 'uncertainty/risk' models (e.g., Pagan, 1984), and these should encourage more rigorous applications in the future.

This area of macro-economics is not well supported by empirical evidence, a fact that is not clear from the text. The models can be made more realistic by integrating energy prices, fiscal policy variables, and even open-economy variables, and this should be emphasized. It would be unfortunate if the reader were left with the impression that the clear, concise models presented in the book are the last word on the relevance of imperfect information for the explanation of real world macro phenomena.

REFERENCES

Buck, A.J. and G. Gahlen (1983) 'On the normality of relative price changes.' Economics Letters 231-6

Engle, R.F. (1983) 'Estimates of the variance of us inflation based upon the ARCH model.' JMCB 15, 286-301

Hercowitz, Z. (1981) 'Money and the dispersion of relative prices.' JPE 89, 328-56 Lucas, R.E. (1973) 'Some international evidence on output-inflation trade-offs.' AER

63, 326-34 Pagan, A.R. (1984) 'Econometric issues in the analysis of regressions with generated

regressors.' International Economic Review 221-47




Pagan, A.R., A.D. Hall and P.K. Trivedi (1983) 'Assessing the variability of inflation.' Review of Economic Studies 50, 585-96

Mizon, G.E., C. Safford and S.H. Thomas (1985) 'Relative price variability and inflation: empirical evidence for the UK.' Mimeo, University of Southampton

Thomas, S.H. and F. Weldon (1986) 'Price variability in Canada.' University of Southampton Discussion Paper, forthcoming

STEVE THOMAS Southampton University

World Monetary Equilibrium: International Monetary Theory in an Historical Institutional Context by John E. Floyd. Oxford: Philip Allan Publishers, 1985. Pp. xi, 212. Can$25.00. ISBN 0-8122-7983-2

The aim of this book is to provide a discussion of the working of the international monetary system that combines a consistent theoretical structure with a feel for the major institutional developments over the last century or so. On the whole it succeeds in this aim, though there are important limitations on the treatment that will restrict the usefulness of the book in advanced international or open economy macro-economics courses.

The basic model is about as standard as it could be. It is a two-country Mundell-Fleming model. Output in each country is equal to consumption plus investment plus government spending plus net exports. Consumption depends upon the domestic interest rate and income (output). Investment depends upon the domestic interest rate and income. Government spending is fixed. Net exports depend upon domestic and foreign income and relative price levels. In addition, demand for real money balances depends upon the domestic interest rate and income. There is no supply side at any stage so consideration alternates between the 'Keynesian' fixed P and variable Y and the 'classical' fixed Y and variable P. This, however, is actually an advantage, since it achieves a maximum level of simplicity and enables the key issues to be seen clearly.

The structure of the book is first to use the model to illustrate the mechanics of adjustment under a gold standard system and then to modify the basic assumptions in order to illustrate the key currency system and flexible exchange rates. The gold standard actually occupies a disproportionate amount of space. However, this section does drive home one very important message that was sometimes neglected in the early monetary approach. It is even being ignored by some modem commentators who ought to know better. They believe that capital has become 'too mobile' and wish to throw sand in the system. This message is that if the capital account can adjust freely to disturbances, the need for rapid current account adjustment (and thus activity changes) is greatly alleviated. The importance of this message is worth the extra space.



Documents

Inflation, Stagflation, Relative Prices, and Imperfect Informationby Alex Cukierman