-18-

exogeneity tests that include the lagged relative prices of food and
energy among the regressors tend to support this conjecture. Thus,
although these findings imply that the aggregate price index contains
information that is relevant for predicting future relative prices ia the
context of a limited set of relative price information, they do not imply
that an aggregate price index would add significant predictive power to
forecasts based on a complete vector of relative prices, and, hence, do
not present any conclusive evidence leading to a rejection of the equili-

brium misperceptions model.


-12-

Il. Empirical Results

Tests of the hypotheses that aggregate prices do not Granger-
cause relative prices were conducted for a sample of seven four-digit:
industries.’ The sample consists of monthly observations for the period
1965 to 1979. Because this period spans the wage-price controls of
August 1971 to April 1974, a natural question arises concerning the
stability of the reduced form equations. The hypothesis of no structural
change versus the alternative of three distinct subperiods--the periods
before, during, and after wage-price controls--was tested in the context
of the null model. Based on equation (9), the regressors included in the
null specification were: lagged relative prices, lagged relative output
shares, a constant, seasonal dummies, and a time trend. All variables
are in logs. To allow for the possibility of breaks in the level and
trend, wage-price control dummies and additional time trends were included
in the second and third subperiods. The tests reject subsample stability
at the 99 percent confidence level in five out of seven industries and
reject stability in the sixth industry at the 90 percent confidence
level.

Having rejected the hypothesis of no structural change across
all three subperiods, the wage-price control episode was omitted and a
test of whether the data permit pooling the pre and post wage-price
control periods was conducted. In all but one industry-~glass containers——
the tests fail to reject subsample stability at a marginal significance
level of 0.05 percent. For the one industry where stability was rejected,
7. The number of industries in the sample is restricted by the availa-

bility of conformable price and output indices. For a description of the
data, see Appendix A.


-22-

fuels and power, and the WPI for all commodities were used. All data
were seasonally unadjusted and seasonal dummies were included in the

estimation.


-3-

both aggregate quantities and relative prices to be exogenous, statistical
inference in the two contexts will not necessarily produce equivalent
results because these tests only examine restrictions on the reduced

form. Any particular set of reduced form restrictions is potentially
generated by a number of structural models.2 Since the set of models

that implies the statistical exogeneity of aggregate quantities and the
set cf models that restricts relative prices to be statistically
exogenous are not identical, the likelihood that the equilibrium
misperceptions paradigm provides a useful approximation is increased if
both sets of restrictions hold. In interpreting this literature, it is
important to recognize that all of these tests are direct tests of the
dichotomous structure of these models--that is, that a real sector repre-
sentation exists that does not include lagged values of nominal variables.
However, because dichotomy is more readily generated from a model in which
anticipated monetary policy is neutral, the tests also provide indirect
evidence on neutrality.

The empirical results provide mixed evidence in support of the
equilibrium models. In roughly half of the industries examined, the
exogeneity of relative prices is rejected. The pattern of rejections
across industries suggests a different dynamic representation for the
shocks, rather than deviations from the competitive paradigm or rational
expectations as an explanation for the failure of the model. Specifically,
supply-side disturbances, which are transmitted across sectors over time,
may play an important role in accounting for comovements in aggregate and
7%. For a general discussion of the issue of observational equivalence as

it pertains to this class of empirical work see the exchange between
McCallum (1979) and Sargent (1979a).


- 19 -

Table 1: Illustrative Relative Price Equation
Null Specification

Dependent Variable: Relative price of cigarettes (S.1.C. 2111)
Period: 1965:7 - 1971:8 and 1974:10 - 1980:6

Variable (Lag (-)) Coefficient Standard Error
Constan: ~.021 +026
Dummy .020 .020

(1974: 10-1980: 6)

Time -00009 -00014
(1965: 7--1980:6)

Time ~-.00002 -00016
(1974: 10-1980:6)

Relative Price (-1) +844 +091
(-2) -.072 +120
(-3) -.072 122
(-4) 094 121
(-5) -.030 +122
(-6) -071 +091
Relative Output (-1) -030 +028
(-2) 028 +029
(-3) -.013 +031
(-4) -.047 +030
(-5) +022 +030
(-6) -.053 028

Note: Seasonal dummies were also included in the regression, but are not
reported here.


IFDP
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Please address requests for co

International Finance Discussion Papers

TITLES

1986

Comovements in Aggregate and Relative
Prices: Some Evidence on Neutrality

Labor Market Rigidities and Unemployment :
the Case of Severance Costs

A Framework for Analyzing the Process
of Financial Innovation

Is the ECU an Optimal Currency Basket?

Are Foreign Exchange Forecasts Rational?
New Evidence from Survey Data

Taxation of Capital Gains on Foreign
Exchange Transactions and the Non-neutrality
of Changes in Anticipated Inflation

The Prospect of a Depreciating Dollar
and Possible Tension Inside the EMS

The Stock Market and Exchange Rate Dynamics

Can Debtor Countries Service Their Debts?
Income and Price Elasticities for Exports
of Developing Countries

Post-simulation Analysis of Monte Carlo
Experiments: Interpreting Pesaran's (1974)
Study of Non-nested Hypothesis Test Statistics

A Method for Solving Systems of First Order
Linear Homogeneous Differential Equations
When the Elements of the Forcing Vector
are Modelled as Step Functions

International Comparisons of Fiscal Policy:
The OECD and the IMF Measures of Fiscal
Impulse

An Analysis of the Welfare Implications of
Alternative Exchange Rate Regimes: An
Intertemporal Model with an Application

~-25-

AUTHOR(s)

B. Dianne Pauls

Michael K. Gavin
Allen B. Frankel
Catherine L. Mann

Hali J. Edison

Kathryn M. Dominguez

Garry J. Schinasi

Jacques Melitz
Michael K. Gavin
Jaime Mar quez

Caryl McNeilly

Neil R. Ericsson

Robert A. Johnson

Garry Schinasi

Andrew Feltenstein
David Lebow
Anne Sibert

pies to International Finance Discussion

Papers, Division of International Finance, Stop 24, Board of Governors of
the Federal Reserve System, Washington, D.C. 20551.


-21-

Data Appendix

The relative price and output share data were constructed using
conformable price and output indices at the four-digit industry level of
disaggregation. The industries in the sample were:

SIC CODE

2084 - Wines and Brandy

2111 - Cigarettes

2822 - Synthetic Rubber

2824 - Man-made Fibers

3221 - Glass Containers

3251 - Brick
3334 - Aluminum

The market-specific prices were constructed from the Industry-
Sector Price Indexes published by the Bureau of Labor Statistics. These
indices are based on regroupings of the Wholesale Price Index to correspond
to industries rather than the end use of the product. The sample period
generally begins in 1965 with the availability of these series and ends
in 1930, when the weighting procedure used to compute the indexes was
substantially revised. Relative prices were calculated as the logarithmic
difference of the Industry-Sector Price Index and the Wholesale Price
Index for all manufacturing, which was taken to be the aggregate price
level,

The industry shares of output were constructed from corresponding
subcomponents of the Industrial Production Index published by the Board
of Governors of the Federal Reserve System. These were computed as the
logarithmic difference of industrial production for the industry and
indust:rial production for all manufacturing.

For the supply shock variables, the relative prices of food and

fuel, the logarithmic differences between the WPI for farm products, and


-16-

capture these interdependencies between lagged sectoral prices. In
terms of the above tests, the exogeneity restrictions may be rejected
in a subset of the industries examined because the aggregate price
level is proxying for the omitted variables, either lagged relative
prices in other sectors or real shocks to tastes and technology.

At least one of these explanations, that asymmetries in the
dynamic effects of supply shocks contributed to the failure of exogeneity,
can be tested. Taking the lagged relative prices of food and energy as
representing the supply shocks, the exogeneity tests for the industries
with rejections were rerun including these variables among the regressors.
It should be noted that, to the extent that the energy shock induced
changes in technology, the relative price of energy may also proxy for
real shocks to technology. The results based on this specification,
shown in the lower portion of Table 2, fail to reject the exogeneity
restrictions in all but one industry, suggesting that intersectoral
differences in the timing of supply shocks and/or serially correlated
real shocks to technology may have accounted for the previous evidence
against the model.

III. Conclusion

This paper proposes an alternative way of addressing the question
of whether anticipated monetary policy is neutral. Rather than confronting
the theory with observations on aggregate quantities and nominal variables,
the tests focus on comovements in relative and aggregate prices. This
approach cuts to the heart of the neutrality issue because relative price
changes are the mechanism for monetary policy to affect real activity

in most macroeconomic models. The tests of neutrality examine a kind


-8-

first condition, that aggregate disturbances be uncorrelated with all
lagged relative disturbances seems plausible given relative disturbances
are defined to net out in the aggregate. This property follows from the
assumptions that prices are flexible and relative shocks are drawn from
the same distribution with a mean of zero. Thus, there is, for instance,
no basis for the policy that determines aggregate demand to respond to
relative excess demand or supply in a particular sector. The second
condition, that relative disturbances be uncorrelated with lagged aggre-
gate disturbances, does not rule out any non-neutrality per se. Rather,
it only limits the channel whereby lagged aggregate disturbances affect
market-specific behavior, so that they impinge upon particular sectors
either through lagged output—both sectoral and aggregate—or lagged
prices and not through the relative disturbance term.

Assuming markets clear instantaneously, we can equate (1) and

(2) and solve for the market price under partial information:
pe(z) = [1-By(z)] E(pe|Ie(z)) + By(z)Mp-7- y(z)Aq(L)y¢-1 (z)
~ y(2)AQ(L) yey - ¥(2)A3(L)(pe-1(z) - pe-1)
+ By(z)ug - y(z)v~e + y(z)eg(z) (3)
where: y(z) = 1/(a8(z) + ad(z))

44(L) = Aq) - rsa) for i=1,2,3, and each of these newly-
defined lag distributions is assumed to be one-sided and
to have a one-sided inverse.

The model is solved using the method of undetermined coefficients.

Conjecturing the reduced form for the aggregate price level gives:
Pe = Meny + 1y(L)yg-z + M2(Bug- ve) (4)

Given agents observe local prices more readily than they observe

prices in other markets, they face an optimal filtering problem. Individuals


—5-
s s s s
ye(z) = a(z)[p_e(z) — ECpe|Te(2))] + ATG )ye-1 (2) + A2C)¥e-1
s s
+ 43(L)(pp-1(z) - pe-1) + ve + &e(2) (1)
d d
ye(z) = -a(z)[pe(z) - E(pe|Te(z))] + BME - E(pe|Te(2))]
d d d d
+ Aq(L)yp-1(z) + AQ(Lyg-2+ 43(L)(pe-1(2) - Pe-2) + ee(2) (2)

s d
where: y_(z), ye(z) = log of supply, and demand, respectively, in market z.

pe(z) = log of price in market z.

E(pe [Te (z)) = expectation of average economy-wide log of price
conditional on information available in market z~-
Ig(z).

s d

a(z), a(z) = relative price elasticity of supply, and demand

s d

in market z, a(z)>0, a(z)>0.

vO = economy-wide average real disturbance.

8 d
e¢(z), e¢(z) = relative disturbance to supply, and demand
in market z.

8 = elasticity of demand with respect to real balances, 8 >0.
Me = log of the money supply.

8 s s d d d
Aq(L), AQ(L), 43(L), and Aq(L), A2(L), 43(L), represent
one-sided polynomials in non-negative powers of the lag operator.

According to equations (1) and (2) the distribution of demand
ard supply across markets depends on the perceived distribution of relative
prices, together with the realizations of sector-specific shocks — ee(z)
and ef(2). In the "islands" paradigm of Lucas(1973), a single good is
traded. Perceived relative prices are the primary determinant of local
supply and demand decisions because they represent arbitrage opportunities.
In a multi-good context, agents' willingness to change markets in response

to perceived relative prices will depend upon the substitutibility of the


-4-

relative prices during the 1966 to 1980 period. Furthermore, the results
of the exogeneity tests that include proxies for the supply-side stocks
tend to support this conjecture. Viewed in this light, these findings
suggest that the aggregate price level may add significant predictive
Power because it is a proxy for omitted real variables, and, therefore,
the results do not pose any conclusive evidence leading to a rejection of
the equilibrium model.

I. An Illustrative Model

Previous studies have adopted the Phelps-Lucas model of informa-
tionally separate markets to a multi-good world and used it as a vehicle
for explaining relative price behavior. (Parks (1977), Cuikerman (1979),
and Hercowitz (1981)). A modified version of Hercowitz's (1981) multi-market
model is used for illustrative purposes. The economy consists of a continuum
of markets, each trading a different good. At each date t, any individual
agent transacts in only one market. It is assumed that markets are
competitive so that agents take their own local prices, Pt(z) as given.
Both consumers and producers locate across markets based on perceived
relative prices. The basic tenet of the equilibrium misperceptions theory
is that agents observe their own local prices more readily than they
observe prices in other markets, and hence more readily than they observe
the aggregate price level. Consequently, agents evaluate relative prices
given current knowledge of their own market price and their conditional
expectation of the aggregate price level.

Indexing markets by z, supply and demand in the various markets
are represented by the following stylized set of decision rules, expressed

in log-linear form:


-17-

of classical dichotomy proposition that characterizes a major class of
models in which anticipated money growth is neutral--equilibrium models
with misperceptions. The proposition maintains that, given the past
history of an appropriately defined set of real variables, today's relative
price structure is independent of expected movements in the general price
level. Under the condition that expectations are formed rationally,
these restrictions are equivalent to the econometric exogeneity of relative
prices with respect to the aggregate price level. Granger-Sims causality
tests are then used to examine this empirical implication of the model.

The evidence from a cross-section of industries provides mixed
results for the equilibrium models. The exogeneity of relative prices
with respect to the aggregate price level is rejected in three out of the
seven industries examined. Attempts to explain the cross-sectional
variation in the results in terms of the failure of a particular assumption
of the model find no correspondence between either the degree of market
power or the proximity to an auction market and the exogeneity test
results.

It is suggested that the dynamic representation of the shocks
in the model is too restrictive to capture adequately real disturbances——
either shocks to tastes and technology or commodity price disturbances.
To the extent that changes in technology are induced by changes in relative
factor costs, and supply-side disturbances are transmitted across sectors
over time, the reduced form for relative prices needs to be amended to
encompass these interdependencies. In the absence of an extensive set of
lagged relative prices in other sectors, the aggregate price level may be

proxying for these interindustry disturbances. The results of the


-7-

There are three sources of disturbances in the economy--nominal
aggregate disturbances or innovations in money growth, real aggregate
disturbances and relative disturbances. Assuming the rate of growth of
money is serially uncorrelated, the money supply is given by:

Me = Mp1 + Ut
Because equilibrium models with misperceptions provide no channel for
predictable components of money growth to affect relative prices, no
gererality is lost by assuming this form for money growth.

Real disturbances in this model are decomposed into an economy—
wide average shock to supply--vt--and relative shocks to supply and
demand in the various markets-— eg(z) and et(z). Since vy represents
the aggregate real disturbance that is common to all markets, the relative
disturbances include both market-specific components of aggregate real
disturbances and such relative shocks as a redistribution of demand
between two ‘narkets. Thus, the relative disturbances net out by construc—
tion: Se_(z) dz = 0, where e¢(z) = eicz) - eg(z) is the net
excess demand disturbance in the market z- ,

The distributional assumptions regarding the disturbances are:

ut ~ NCO, 3)

ve ~ NCO, 3)

e¢(z) ~ NCO, a)

In addition, it is assumed that each type of disturbance is serially uncor-
related and that all disturbances are mutually orthogonal for all t.3 The
3. In terms of the model developed here, it is sufficient that the
aggregate disturbances and the relative disturbances be uncorrelated at

nonzero lags and leads. However, imposing the additional structure
simplifies the exposition.


-23-
References

Barco, R., "Rational Expectations and the Role of Monetary Policy",
Journal of Monetary Economics, vol. 2, (January 1976), pp. 1-32,

» “Unanticipated Money Growth and Unemployment in the U.S.",
American Economic Review, vol. 67, (March 1977), pp. 101-115.

Cuikerman, A., “Relative Price Variability, Inflation, and the Allocative
Efficiency of the Price System", Journal of Monetary Economics,
vol. 9, (March 1982), pp. 131-162.

Geweke, John, “Inference and Causality in Economic Time Series Models",
in Handbook of Econometrics, Griliches, Z., and M, Intrilligator,
(eds.) North Holland, New York, 1983,

Hansen, . and T. Sargent, “Formulating and Estimating Dynamic Linear
Rational Expectations Models", Journal of Economic Dynamics and
Control, vol. 2, (February 1980), pp. 7-46.

Hercowitz, Z., “Money and the Dispersion of Relative Prices," Journal
of Political Economy, vol. 89, (April 1981), pp. 328-356.
» “Money and Price Dispersion in the United States," Journal

of Monetary Economics, vol. 10, (July 1982), pp. 25-38.

Lucas, Robert E. Jr., and Thomas J. Sargent, Rational Expectations and
Econometric Practice, University of Minnesota Press, 1981,
Pp. xi-xxxiv.

__» “Some International Evidence on Output-Inflation Trade-offs",
American Economic Review, vol. 63, (June 1973), pp. 326-335,
Sat mconomic Review

McCallum, Bennett, "On the Observational Inequivalence of Classical and
Keynesian Models" Journal of Political Economy, vol. 87, (April
1979), pp. 395-402.

Parks, R., “Inflation and Relative Price Variability", Journal of Political
Economy, vol. 86, (February 1978), Pp. 79-96.

Pauls, B. Dianne, "Relative Wages, Wage Determination, and Inflation",
(unpublished) Dartmouth College 1981.

Sargent, T.J., "A Classical Macroeconometric Model of the United States",
slournal of Political Economy, vol. 84, (April 1976), pp. 207-238,

_» "Causality, Exogeneity, and Natural Rate Models: Reply to C. R.
Nelson and B. T, McCallum", Journal of Political Economy., vol. 87,
(April 1979), pp. 403-411,



International Finance Discussion Papers
Number 285

July 1986

COMOVEMENTS IN AGGREGATE AND RELATIVE PRICES:
SOME EVIDENCE ON NEUTRALITY

by

B. Dianne Pauls

NOTE: International Finance Discussion Papers are prelimi:
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished
material) should be cleared with the author or authors.

nary materials


-10-

of the elasticity of net excess demand, is distributed independently
of e¢(z), and solving for the undetermined coefficients gives the

following expressions for the aggregate price level and the undetermined

coefficients:
Pe = Mea ~ [04](L) + A2(L))/B lye + [8/8 + ¥ (1 - ©)] (Bug - v_e) (8)
where: Y = Sy(z)dz = average of the reciprocal of the relative
price elasticity of excess demand across
markets.
32 2 32 2 ~. 2
© = (B oy + Boy)/(B oy + Boy + (1/Y)o¢)
Ny(L) = - (Ay (L) + A2(L))/8
Ng = 8/8 + ¥Q - 8)

Substituting these coefficients into (7), the relative price in

market z is given as:
pe(z) — Pe = ~ y(z)Ag(L)(yp-1(z) - ye-1) ~ y(z)A3(L)(pe-1(2) - pe-1)
+ (yz) - Y)(1 - ©)(Bug - v_) + [8/8 + ¥(z)(1 - 0)] e¢(z) (9)

In order for equation (9) to be a rational-expectations solution,
the information set that was used in projecting future relative prices
should be consistent with the description of the relative price process
contained in equation (9). Comparing equations (1) and (2) with equation
(9), the solution meets this criterion.5

According to equation (8), innovations in the aggregate price
level are a function of But - Vt- Thus, equation (9) indicates that,
while innovations in relative prices and innovations in the aggregate
price level are contemporaneously correlated, aggregate prices do not
Granger-cause relative prices. Although this implication was derived in

5. However, the information set used is not unique in providing an
internally consistent solution.


-9-

observe a composite of the three disturbances contained in the current
market price and have to infer the aggregate and relative components.
The information set of agents in market z, I¢(z), consists of current
local prices, pe(z), lagged values of market prices and output in all
markets, the parameters of the model, and the first and second moments
of the probability distributions of the random disturbances. If expecta~
tions are rational then agents update their forecasts of the aggregate
price level based on equation (4).

E(pelTe(2)) = Men + WCdyena + W2BCBue ~ velTe(2)) (5)
The optimal updating procedure uses agents' knowledge of the historical
sources of variability in the economy to filter the composite disturbance
contained in the current market price, Bur - ve + €¢(z)- Substituting

the optimal linear filter into the expectation formla gives:4

22 2
E(pelIe(z)) = Me-z + W1(L)ye-1 + M2 6 oy +o.

JP Oy Toy

22 2 2!
B Oy + Oy + Oe

(Bug - ve + €e(z)) (6)
Replacing the expectation in (3) with (6) yields the reduced
form for the market price:
pe(z) = Me-1 + [C1 - By(z))y(L) — y(z)A2(L) lye-1
a ¥(z)az(L)y¢-1(2) - ¥(z)A3L) (pe=1 (2) -Pe-1)
AN cx = pyle ytp(e20n + og) + v(z){ (Bue - ve teet@)? =

22 2 2
B oy + Oy + Ge

Integrating over markets under the assumption that y(z), the reciprocal

%. The coefficient on the composite disturbance is that proportion of the
variance in market price innovations which has been attributed historically
to aggregate price innovations.


-6-

goods in consumption and production. Allowances for intermarket differ-
ences in the degree of substitutability are made by introducing relative
price elasticities that vary across markets.

Each market is treated as a microcosm of the economy, in that
market supply and demand schedules are expressed as subcomponents of the
aggregate demand and aggregate supply schedules for the economy as a whole.
Thus, the real balance effect enters each market demand function directly.
Real shocks to aggregate supply, such as an exogenous change in produc-
tivity, are represented as a common shift in the supply function in each
market --v_.

The basic modification made to Hercowitz's model is the intro-
duction of dynamics into the demand and supply decision rules. This
alteration is necessary if the real variables are to display cyclical
behavior. The dynamic specification represents intertemporal substitution
possibilities in production and consumption, both of which depend upon
expected future as well as current relative prices. Based on work by
Hansen and Sargent (1979), the dynamic decision rules include lagged
values of the decision variable together with any information that helps
predict future relative prices. Since economic theory generally does not
dictate the information set used by firms and consumers for predicting
relative prices, a general specification, consisting of relative orices
and market output relative to aggregate output, was adopted. In keeping
with the spirit of the equilibrium model, the intramarket dynamics, which

are incorporated in the \ parameters, are constrained to be the same

across markets.


- 20 -

Table 2: Exogeneity Test Results
Tests of Causality from the Aggregate Price Level to Relative Prices

Marginal

Industry Significance
(S.1.C.) Period F-Statistic Level
2084 1966:1 - 1971:8 & F (6, 44) = 1.327 +266
1975:5 - 1975:12 F (12, 38) = 1.419 +200
2111 1966:1 - 1971:8 & F (6, 96) = 5.109 +0001
1975:5 - 1980:6 F (12, 90) = 3.433 +0004
2822 1966:1 - 1971:8 & F (6, 90) = 2.776 +016
1975:5 - 1980:6 F (12, 84) = 1.596 -108
2824 1969:6 - 1971:8 & F (6, 28) = .459 -833
1975:10 - 1980:6 F (12, 22) = .563 +848
3221 1966:1 - 1971:8 F (6, 39) = 1.160 2347
F (12, 33) = .953 -510
1975:5 - 1980:6 F (6, 33) = 2.169 -071
F (12, 27) = 1.548 -168
3251 1966:1 - 1971:8 & F (6, 88) = 3.603 -003
1975:5 - 1980:6 F (12, 82) = 2.830 -003
3334 1968:2 - 1971:8 & F (6, 56) = 1.235 +303
1975:6 - 1980:6 F (12, 50) = .759 +688

ADDENDA:
Causality Tests with Relative Prices of Food and Energy Included Among
the Regressors

2111 1966:1 - 1971:8 & F (6, 84) = 3.836 +0020
1975:5 - 1980:6 F (12, 78) = 2.324 +0134
2822 1966:1 - 1971:8 & F (6, 72) = 1.733 +126
1975:5 - 1980:6 F (12, 66) = .887 3564
3251 1966:1 - 1971:8 & F (6, 68) = .716 +638
1975:5 - 1980:6 F (12, 62) = 1.175 2321



IFDP
NUMBER

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261

260

International Finance Discussion Papers

TITLES

1985
(partial listing)

Expected Fiscal Policy and the Recession
of 1982

Elections and Macroeconomic Policy Cycles

Assertion Without Empirical Basis: An
Econometric Appraisal of Monetary Trends
in... the United Kingdom by Milton Friedman
and Anna J. Schwartz

Canadian Financial Markets:
Proposal for Reform

The Government's

Was It Real? The Exchange Rate Interest
Differential Relation, 1973-1984

The U.K. Sector of the Federal Reserve's
Multicountry Model: The Effects of
Monetary and Fiscal Policies

Optimal Currency Basket in a World of
Generalized Floating: An Application to
the Nordic Countries

Money Demand in Open Economies:
Substitution Model for Venezuela

A Currency

Comparing Costs of Note Issuance Facilities
and Eurocredits

Some Implications of the President's Tax
Proposals for U.S. Banks with Claims on
Developing Countries

Monetary Stabilization Policy in an Open
Economy

Anticipatory Capital Flows and the Behaviour
of the Dollar

Simulating Exchange Rate Shocks in the MPS
and MCM Models: An Evaluation

-26-

AUTHOR(S)

William H. Branson
Arminio Fraga
Robert A. Johnson

Kenneth Rogoff
Anne Sibert

David F. Hendry
Neil R. Ericsson

Garry J. Sehinasi
Richard Meese
Kenneth Rogoff

Hali J. Edison

Hali J. Edison
Erling Yardal

Jaime Marquez
Rodney 4. Mills

Allen B. Frankel

Marcus H. Miller
Arnold Kling

Arnold Kling


of aggregate and relative prices. The reasons for concentrating on
these particular modeis are twofold. First, it is important to see how
far we can push the competitive paradigm in explaining the covariation
in the data. And second, this is the class of models which generates
the greatest concern over the potentially destabilizing effects of
macroeconomic policies. Specifically, in a world where markets clear
but information is incomplete, monetary disturbances May create
distortions in relative prices and thereby decrease the allocative
efficicacy of relative price signals.

The paper begins with a description of a prototype multi-market
equilibrium model, which follows along the lines of Hercowitz (1981). The
major innovation in the model is the introduction of dynamics into the
demand and supply decision rules. Using this model as an example, it is
shown that the characteristic assumption of equilibrium models, that
prices are flexible, implies a kind of neutrality proposition. Given the
past history of a spanning set of relative prices, today's relative price
structure is independent of anticipated movements in the general price
level. Since, under rational expectations, these restrictions are
equivalent to the econometric exogeneity of relative prices, Granger-3ims
causality tests provide a natural method for testing this proposition,

The empirical methodology is similar to that used by Sargent
(1976), Barro (1977), and Sims (1980). Rather than directly examine
comovements between relative prices and nominal variables, these studies
focus on the implications of an equilibrium model for the exogeneity of
aggregate quantity variables, such as GNP and unemployment, with respect

to nominal variables. Although a given equilibrium model may restrict:


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the Granger causality tests were performed separately on each portion of
the sample.

The tests that relative prices are not Granger-caused by the
aggregate price level entail F tests on lags of the aggregate price level
in equation (9). However, in order for the computed test statistic to
have an F distribution, the residuals must be independently and normally
distributed. Consequently, after pretesting for the appropriate lag
length for the relative prices and relative output shares for each industry,
Lagrange multiplier tests were conducted to verify that there was no
remaining serial correlation in the residuals. Because pretesting for
the appropriate lag length for the causal variable—-in this case the
aggregate price level--alters the significance level of the exogeneity
tests, the Granger test statistic is computed for alternative lag
specifications for this variable using six- and twelve-month lags.

Tables 1 and 2 present an illustrative relative price equation
based on one industry and a summary of the F statistics for the exogeneity
tests for all the industries in the sample. The equation shown in Table 1
represents the null specification corresponding to equation (9). This
equation is only meant to be illustrative, as the specification of the
lag length in the null model varies across industries. Due to differences
in lag length and data availability across industries, the estimation
period varies somewhat among the different industries, although it
generally covers the period 1966 to 1980, omitting the wage-price
control observations.

The exogeneity test results displayed in Table 2 are mixed. The

exogeneity of relative prices with respect to the aggregate price level can


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industries characterized as customer markets, the data are consistent
with an equilibrium model.

It is a general property of the causality tests that differences
in the dynamic properties of the shocks from those assumed in the model
can lead to the failure of exogeneity. In particular, it is assumed that
the market~specific shocks to demand and supply, f(z) and ee(z) are
serially uncorrelated. However, as these disturbances include unobserved
shocks to tastes and technology, there is no reason to presume that they
might not be serially correlated. In that case, as Sargent (1979a)
demonstrates, provided that the real variables that are used as regressors
are not sufficient to span the space containing the real shocks, lagged
nominal variables can add predictive power in an equation describing the
real variables because they help predict the unobserved shocks to tastes
and technology.

Another possible difference in the dynamic properties of the
shocks is that the aggregate real shocks may have a variable timing
across sectors of the economy. Moreover, the model was developed in the
context of aggregate shocks that have a coincident impact on the various
sectors of the economy. Although shocks to nominal aggregate demand are
apt to exhibit this behavior, supply shocks, which were prevalent in the
1970's, tend to have an uneven impact across industries, both in terms of
timing and magnitude. Differences in magnitude are allowed for in the
market-specific shock, but variable timing is not. In an environment
where aggregate disturbances have a variable timing across sectors of the
economy, information about the transmission of shocks among industries

becomes relevant. As a result, the reduced form needs to be amended to


Comovements in Aggregate and Relative Prices:
Some Evidence on Neutrality

by
B. Dianne Pauls*
Introduction

Within a wide class of macroeconomic models, including both
Keynesian and classical rational expectations models, the channel for
monetary policy to affect real activity is through changes in actual or
perceived relative prices and wages. As a result, if anticipated monetary
policy is to have real effects, these should appear in the relative
wage and price structure. For example, suppose anticipated monetary
policy impinges on the real sector through changes in the real rate of
interest. In that case, any Mundell-Tobin effects will be reflected in
the cross-sectional data as changes in the relative wages and prices of
capital-intensive versus labor-intensive industries. Therefore, it is
appropriate, in gathering evidence on the debate over the neutrality of
anticipated monetary policy, to examine directly comovements between
relative prices and relative wages on the one hand, and nominal variables
on the other.

This paper takes one class of models in which anticipated
monetary policy is neutral, equilibrium models with misperceptions, and
derives a set of testable restrictions on the joint time-series behavior
® The author is a staff economist in the International Finance Division,
Board of Governors of the Federal Reserve System. This paper is the
revision of an earlier paper entitled, “On the Causal Implications of
Inflation and Relative Price Dispersion.” The author gratefully
acknowledges helpful comments from Peter K. Clark, Stanley Fischer,
Robert Litterman, Christopher Sims, Robert Solow, and Stuart Weiner.
The views expressed herein are the sole responsibility of the author
and not of the Board of Governors of the Federal Reserve or its staff.

1, Similar tests of the invariance of the relative wage structure with re-

spect to anticipated monetary policy appear in B.D. Pauls, “Relative Wages,
Wage Determination, and Inflation.”


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, “Interpreting Economic Time Series,” Journal of Political
Economy, vol. 89, (April 1981), pp.213-248.

» Macroeconomic Theory, Academic Press, New York, 1979.

Sims, C., "Macroeconomics and Reality”, Econometrica, vol. 48, (January
1980), pp. 1-48.

, "Money, Income and Causality”, American Economic Review, vol. 62,
(September 1972), pp. 540-552.


ABSTRACT

This paper develops an alternative test of the neutrality of anticipated
monetary policy. A multi-good equilibrium model along the lines of Barro
and Hercowitz is used to derive a neutrality proposition for anticipated
movements in the aggregate price level and to demonstrate econometrically
its equivalence to the exogeneity of relative prices with respect to

the aggregate price level. Multivariate causality tests provide a

basis for testing these restrictions. The empirical results provide
mixed evidence for the equilibrium models, while the variation in the
findings across industries suggests a role for supply-side disturbances

ir. explaining comovements in aggregate and relative prices.


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the context of a particular, highly stylized example, it embodies a kind
of classical dichotomy property that is a general feature of equilibrium
models. The characteristics of these models, that expectations are
rational and wages and prices are flexible, imply that only the “surprise”
component of the nominal variables affects the real variables of the
system. While the dynamic form of the decision rule allows the effects
of agents' past forecast errors to persist, in a market-clearing framework,
their effects on current relative prices will be mediated through lagged
relative prices and output shares. Thus, all the relevant history for
predicting the future path of the real variables is embedded in the past
realizations of the real variables, including, in the more general case
where market dynamics vary across sectors, relative prices in other
sectors of the economy. As a result, these models dichotomize in expected
values. Econometrically, this property implies that an appropriately
defined set of relative prices and other real variables--in this case
relative output shares--is jointly exogenous with respect to the aggregate
price level. Thus, the causality tests directly examine the dichotomy
proposition outlined above, and bear indirect evidence on the neutrality
issue in the sense that dichotomy is more readily generated from the

class of models in which money is neutral.

. in addition, there is the technical requirement that the relevant
vector autoregressions for predicting relative prices be one-sided in
lagged observations. (Geweke (1983)). This assumption of the model is

tested jointly with the implications of market-clearing and rational
expectations.


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be rejected at the 95 percent confidence level in three out of the seven
industries examined. These are cigarettes, synthetic rubber, and brick.
A consistent interpretation of the results requires an explanation of' the
differences in the findings across industries, in addition to a rationale
for the observations that are at variance with the model. On this basis,
the failure of rational expectations is not a likely explanation for the
rejection of the exogeneity restrictions because it is difficult to see
why expectations should be formed rationally in some industries and not

in others. Potential explanations do include departures from the competi-
tive paradigm and non-market clearing. Regarding non-competitive behavior,
there is no correspondence between concentration ratios and causal order-
ings across industries.

To determine whether deviations from market-clearing might
account for the results, the industries in the sample are classified
according to whether they can be primarily characterized as customer or
auction markets. Among the industries examined, cigarettes, wines and
brandy, and, possibly, glass containers are likely auction markets, g:iven
they are primarily final products. The remaining industries——synthet:ic
rubber, man-made fibers, brick and aluminum—largely consist of interne-
diate goods and building materials. As such, they are apt to be customer
markets in which there is some contractual relationship between the
supplier and the industry purchasing the intermediate input. According
to this framework, rejections of the model reflecting departures from
market~clearing are expected to be concentrated in customer markets.
However, contrary to this prediction, rejections of the exogeneity

restrictions cut across both categories of markets, and in many