A Test of Price Sluggishness in the Simple Rational Expectations Model: U.K. 1950-1980

We introduce partial adjustments in the rational expectations model in the conventional way of empirical models. First, we solve the model for its full equilibrium solution, with lags in the supply function only. Then we assume that the actual variable (in our case the demand for money or the price level) moves sluggishly towards its full equilibrium value. This way of introducing lags can only be justified as an approximation to an underlying process that cannot be modelled and tested precisely. It has a long history in empirical economics because of its tractability, though it is not entirely satisfactory in theory. Section I derives the equations for the two adjustment mechanisms. Section II tests the model by applying it to annual UK data for the years 1950-80. Our results show that the hypothesis of partial adjustment in the monetary sector is easily rejected by the data. Sluggish price adjustment cannot be rejected. Our best estimate of the speed of price adjustment indicates that only 25 %of the gap between actual and market-clearing prices is closed during a year. Our results favour the hypothesis of sluggish price adjustment against the alternative of continuous market clearing with lags in the monetary sector.

The Economic Journal (with Chris Pissarides)

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