Sluggish Price Adjustments and the Link between Money and Price

Abstract

The simple quantity theory of money asserts that, because the velocity of money and fullemployment output are constants, if the money supply doubles, the price must also double [15]. This view of the quantity theory of money is also supported by the policy ineffectiveness proposition put forward by Lucas [16], Sargent and Wallace [20], and Barro [1]. The policy ineffectiveness proposition asserts that real variables like output and unemployment respond only to unanticipated movements in the money supply, but do not respond to anticipated money supply associated with the systematic feedback rules. One of the premises essential to the validity of this proposition is the perfect flexibility of prices. The corollary of the policy ineffectiveness proposition, as expounded by Gordon [12] in invalidating this propositin, is that because output does not respond to anticipated money supply changes and remains at the natural level, the price responds contemporaneously and proportionately to the anticipated changes in the money supply. This conclusion is also consistent with Barro's hypothesis that perceived movements in the money stock ... imply equiproportionate, contemporaneous movements in the price level [3, 565-66]. This one-to-one relationship between the anticipated money supply and the price has also been shown theoretically by Barro [1] and Hercowitz [13]. It is this conclusion that needs to be tested by accounting for the speed of adjustments of prices. The purpose of this study is to explore theoretically and empirically the link between money supply and price levels by incorporating a gradual price adjustment mechanism. More specifically, this study examines (a) the one-to-one relationship between the log of current money stock and the log of the price purported by Barro [3]; (b) effects of unanticipated money growth on the aggregate price, and (c) importance of anticipated money growth in determining the price level, given the current money stock and the current and lagged values of the unanticipated money growth. The key element of the study is the realization that the economy is comprised of markets with differing degrees of price adjustments. Numerous cases of price stickiness can be identified in modern economies as enumerated in survey work by Blinder [4]. Also, for instance, Devadoss and Choi [6] observe that the U. S. agricultural program's price-fixing policies such as price