Date of Original Version

10-1980

Type

Article

Abstract or Description

When changes occur, people do not know how long they will persist. Using a simple stochastic structure that incorporates temporary and permanent changes in an augmented IS-LM model, we show that rising prices and rising unemployment — stagflation is likely to follow a large permanent reduction in productivity. All markets clear and all expectations are rational. People learn gradually the permanent values which the economy will reach following a permanent shock and gradually adjust anticipations. In our model, optimally perceived permanent values take the form of a Koyck lag of past observations.

DOI

10.1016/0304-3932(80)90002-1

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Published In

Journal of Monetary Economics , 6, 4, 467-492.