This chapter analyzes an economy in which decisions depend not just on the changes that occur but also on their persistence. The economy is subject to real shocks to the labor, commodity, and money markets and to nominal shocks to the money stock. Each shock has a permanent and a transitory component.
Individuals know both the deterministic structure and the stochastic structure of the economic model. They use all available information to form optimal forecasts of the permanent values of relevant variables, but this information does not permit them to distinguish permanent and transitory changes as soon as they occur.
All markets reach equilibrium and clear each period. The prices and quantities at which the markets clear depend, however, on the perceptions individuals in the aggregate hold about the persistence of the shocks that have occurred. Because people learn whether changes are permanent or transitory only by observing what has occurred, perceptions about permanent values change gradually, and differences between expected and actual permanent values can persist for a time. The resulting confusion explains the phenomenon known as stagflation.
This chapter shows that a large permanent reduction in productivity causes on impact both an increase in unemployment that persists for a time and an increase in prices. As information about the permanence of the shock accrues, real wages adjust toward their new equilibrium value, but during the transition, real wages are “sticky.”