Price Inertia and Policy Ineffectiveness in the United States, 1890-1980.

This paper introduces a new approach to the empirical testing of the Lucas-Sargent-Wallace (LSW) "policy ineffectiveness proposition," which compares the LSW hypothesis with an alternative that states that prices respond fully in the long run, but only gradually in the short run, to nominal aggregate demand disturbances. The empirical equations, estimated for a new set of quarterly data extending back to 1890, exhibit uniformly high responses of real output and low responses of price changes to anticipated changes in nominal GNP. The paper compares and tests three alternative methods of introducing "persistence effects" into the LSW framework. This paper presents new empirical test of the LSW policy ineffectiveness proposition that introduce three major improvements on previous studies. First and most important, unlike earlier papers that tested the LSW proposition in isolation from any plausible alternative, this paper explicitly compares the LSW characterization of price and output behavior with the major competing hypothesis underlying conventional analyses of monetary policy, that prices adjust gradually to nominal demand changes whether anticipated or not. A single reduced-form equation for the inflation rate is developed in which the LSW and gradual-price-adjustment hypotheses appear as special cases, which allows coefficient estimates to distinguish the two. The second innovation here is a much expanded set of U.S. quarterly time-series data extending over the entire period between 1890 and 1980. Unlike previous studies that have been limited to 30 years of postwar quarterly data, the sample space here is extended to 90 years. The characterization of price and output behavior in more than 200 new quarterly data observations is of independent interest outside of the context of the LSW debate. [ABSTRACT FROM AUTHOR]