Expectations and the Neutrality of Money

This paper provides a simple example of an economy in which equilibrium prices and quantities exhibit what may be the central feature of the modern business cycle: a systematic relation between the rate of change in nominal prices and the level of real output. The relationship, essentially a variant of the well-known Phillips curve, is derived within a framework from which all forms of “money illusion” are rigorously excluded: all prices are market clearing, all agents behave optimally in light of their objectives and expectations, and expectations are formed optimally (in a sense to be made precise below). Exchange in the economy studied takes place in two physically separated markets. The allocation of traders across markets in each period is in part stochastic, introducing fluctuations in relative prices between the two markets. A second source of disturbance arises from stochastic changes in the quantity of money, which in itself introduces fluctuations in the nominal price level (the average rate of exchange between money and goods). Information on the current state of these real and monetary disturbances is transmitted to agents only through prices in the market where each agent happens to be. In the particular framework presented below, prices convey this information only imperfectly, forcing agents to hedge on whether a particular price movement results from a relative demand shift or a nominal (monetary) one. This hedging behavior results in a nonneutrality of money, or broadly speaking a Phillips curve, similar in nature to that which we observe in reality. At the same time, classical results on the long-run neutrality of money, or independence of real and nominal magnitudes, continue to hold. These features of aggregate economic behavior, derived below within a particular, abstract framework, bear more than a surface resemblance to