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Chapter 15: Money and Business Cycles I: The
Price-Misperceptions Model.
Chapter Summary:
This is the first of two chapters which use the framework of the equilibrium
business cycle model to demonstrate how monetary shocks could create business
cycles. The conditions under which this could happen are implicit in the chapter
titles themselves; in this case “price misperceptions” and in the next chapter “sticky
prices and wages”.
Students are shown that the historical evidence suggests that although money
is neutral over lengthy time periods, it appears as though it does have important
short term effects. The work of Freidman and Schwartz is particularly influential in
this regard, demonstrating that exogenous fluctuations in the money supply have
occurred regularly and appear to have caused similar fluctuations in real GDP. The
mechanism used in this chapter to explain this observation is the idea of monetary
The results depend on monetary policy catching workers by surprise. The
Lucas hypothesis suggests that this may be more difficult in countries which
normally have high and variable rates of inflation. Paradoxically, countries which
rely heavily on monetary policy to influence the economy are less able to do so than
countries that have historically chosen monetary restraint.
The policy implications for dealing with the model are discussed at length.
Discretion in monetary policy is analyzed using a game-theoretic framework in
which the policymaker’s choice of inflation is chosen on the basis of the public’s
bank’s credibility and transparency which would allow them to reduce inflation rates
with causing temporary reductions in real GDP. The current trend of countries to
move to an explicit inflation rate target is discussed.
I. Effects of Money in the Equilibrium Business-Cycle Model
II. The Price-Misperceptions Model
A. A Model with Non-Neutral Effects of Money
B. Money Is Neutral in the Long Run
III. Rules Versus Discretion
Teaching Tips:
1. The students should be encouraged to think of the rules vs. discretion debate as an
exciting theoretical debate with real policy relevance. The difficulty of timing
discretionary policy correctly is illustrated in a brief Wall Street Journal article titled
2. Although the basic concept of labor supply responding to inaccurate estimates of
the price level is a simple one, the behavior of individuals may be harder for students
to grasp. After all, individual job seekers are not necessarily well informed enough
3. The analysis of optimal monetary policy using concepts from game theory is an
important feature of the model. For students unfamiliar with game theory, the game
4. The discussion of figure 15.4 is important, but difficult for students to intuitively
understand. Therefore, sufficient time and concrete examples should be used to
Answers to review questions, pg. 388
1. Obtaining information is an economic activity; it generates marginal benefits and
marginal costs. Some of these costs include time, subscriptions to relevant data,
2. A relative price is the opportunity cost of one good expressed in terms of the
other. For example, if bananas cost $1 and dates cost $4, the relative price of dates is
3. Rational expectations does not imply that people are always right. What it implies
is that people will generate unbiased forecasts based on available information.
4. Workers may suffer from “money illusion” if they fail to anticipate changes in the
price level as they occur. This is more likely to be the case if the central bank breaks
Answers to Problems for discussion, pg. 388-389
5. The model predicts that deviations from trend GDP will be temporary. Persistent
effects on GDP can arise from other sources. For example, a shock that produces
6. Correlation is not causation. It could be that the central bank is forecasting
economic activity accurately, and adjusting the money supply to keep up with
7. a. If people accurately anticipate the effects of monetary policy on inflation, and
assuming there are no impediments to changing nominal prices, then nominal prices
will adjust to maintain real wages, real rental rates for capital services, real interest
rates, etc. If regulations, “menu costs”, long term contracts, or other impediments to
