The Forward Exchange Rate, Expectations, and the Demand for Money-The German Hyperinflation: Reply

A major difficulty in incorporating the role of inflationary expectations in empirical work has been the lack of an observable variable measuring expectations. Thus, for example, in analyzing the demand for money during hyperinflation, Phillip Cagan in his classic contribution constructed a time-series of expected inflation using a specific transformation of the time-series of the actual rates of inflation. There are two conceptual difficulties with such an approach: first, the choice of the specific transformation used to generate the series of expectations is to a large extent arbitrary; and second it assumes that expectations about future prices are based only on past and present prices. Recent empirical work that was stimulated by Cagan's pioneering study elaborated on some aspects of the estimation procedures (see Thomas Sargent and Neil Wallace; Sargent 1977; Joseph Bisignano; Paul Evans; Rodney Jacobs 1975; Mohsin Khan 1975), and the functional form (see Robert Barro 1970; Benjamin Eden 1976). The ongrowing literature concerning rational expectations (for example, John Muth 1961; Robert E. Lucas) has led to an examination of the conditions under which the adaptive expectations process is "rational" in the sense of Muth (1961). See Sargent and Wallace (1973); Sargent 1977); Benjamin Friedman (1 975a); Michael Mussa. In this paper I propose a direct measure of expectations which is then incorporated in the analysis of the demand for money during the German hyperinflation. The major virtue of the proposed direct measure is that it is not derived from a specific mechanistic formula, but rather, it reflects the expectations of economic agents as manifested in market prices. The direct measure is based on data from the forward market for foreign exchange. The plan of the paper is as follows: Section I describes the direct measure of expectations and provides evidence on the efficiency of the foreign exchange market. Section II incorporates these expectations in estimating the demand for money. The issues that are discussed in that section involve the proper functional form, the proper price deflator, the stability of the demand for money during the various phases of the hyperinflation, possible lags of adjustment and the resultant estimates of short-run and longrun demand functions, and the role of price variability and uncertainty in the specification of the demand for money. Section III deals with the issue of inflationary finance and the money supply process. In this context I examine the interrelationships between money and prices and discuss some aspects of "causality" by analyzing the time-series properties of money and prices. Section IV contains some concluding remarks. *University of Chicago and Tel-Aviv University. I am indebted to John Bilson and Rolf Banz for suggestions and efficient research assistance. In revising the paper I have benefited from numerous suggestions by Robert Barro, Phillip Cagan, Kenneth Clements, Rudiger Dornbusch, Paul Evans, Stanley Fischer, Benjamin Friedman, Milton Friedman, John Gould, Zvi Griliches, Arnold Harberger, Albert Hart, James Heckman, Edi Karni, Mohsin Khan, David Laidler, Edward Lazear, Robert Lucas, Huston McCulloch, Merton Miller, Franco Modigliani, Michael Parkin, Aris Protopapadakis, Thomas Sargent, Jose Scheinkman, Larry Sjaastad, Jerome Stein, Lester Telser, and Arnold Zellner. Financial support was provided by a grant from the Ford Foundation.