EE432 2010: Revision for Mid-term

Q1: What do we mean by the following statement, " the key source of uncertainty is the fact that workers cannot always discern whether they are experiencing a relative price change or a general price change"?

Both Friedman and Lucas agree that, in the world of completely flexible prices, the only reason that any individual firm will produce more or less than the 'normal' or 'natural' level is if it thinks there is really a greater or lesser demand for its goods, relative to other goods in the economy. As the analogy I used in the lecture went, the firm's entrepreneur may expand output if he believes he has become the new Steve Job, whose product is relatively more popular than others. In terms of prices, this means there is a relative price change: the price of my product may now increase, while prices of other goods are unchanged, because there's more demand for my good only.

However the price of my good can rise for 2 reasons. (1) There can be a relative price change, in the sense that my good really becomes more popular and there's more demand for it. If I knew that was really the case, I would quite rightly expand my output (the same way Steve Job expands his company in response to greater demand). Or (2), there's simply an increase in aggregate demand stemming from expansionary monetary policy for example. Here, everyone's prices will tend to increase, and there's a change in general prices rather than relative prices. If I knew that this was the case, my reaction would be to produce the same amount I did before, but simply readjust my price in line with the new general price level.

In practice, firms cannot always differentiate between the two. So even if there is purely an aggregate demand shock, which affects general prices only, some firms may mistakenly (given their imperfect information about both the relative price and general price shocks) think that there have been some relative price changes and hence they will respond by changing the output produced. When all firms respond to aggregate demand in the same way, the result is a huge macro level change in output, GDP if you like. This is the mechanism, according to Friedman and Lucas, how changes in aggregate demand can bring about changes in total output, i.e. 'money matters'.