Introduction

This chapter explores the implications of the confusion between temporary and permanent changes in the relative demands for monetary policy and for the allocative efficiency of the price system. We saw in Chapter 9 that confusion between permanent and transitory changes in the level of aggregate productivity can produce the symptoms of stagflation. The confusion between permanent and transitory changes in relative prices also has implications for the allocation of resources across sectors in the economy. This is because producers usually gear their production levels to what they perceive to be permanent relative prices. Erratic monetary policy introduces transitory distortions in relative prices and makes it more difficult for producers to make accurate forecasts of the permanent values of relevant relative prices.

More generally, frequent uncertain shifts in the structure of relative demands and relative supplies make it more difficult to plan production optimally. These effects and others cannot be investigated within the framework of an aggregate model of the type presented in Chapter 9 because they work by reallocating resources across sectors. We therefore move back to a multimarket equilibrium model similar in spirit to the models presented in Chapter 6. Because the discussion here focuses on the permanent–transitory confusion rather than on the aggregate–relative confusion, however, individuals in all sectors are endowed with the same current information.