Endogenous Uncertainty and the Non-neutrality of Money

We study the implications of the Theory of Rational Beliefs to monetary policy. A two-agent OLG model based on Lucas' model is proposed to study such issue. We show that monetary policy in a Rational Beliefs environment can have an important e ect on the characteristics of eco- nomic fluctuations. In Rational Beliefs Equilibria (RBE) money is generi- cally non-neutral unlike Rational Expectations Equilibria (REE) in which money is neutral and monetary policy is ine ective. Without structural knowledge by agents, individuals who hold rational beliefs make decisions based on their di ering expectations. In such an economy nominal prices and real output change not only in response to changes in the exogenous growth rate of money but also in response to changes in the state of beliefs. Endogenous Uncertainty, the internally propagated uncertainty about en- dogenous variables such as beliefs and actions of other agents and prices, is the major cause of such fluctuations. The rational mistakes of agents in RBE can amplify or reverse the effect of an expansionary monetary policy leading to higher or lower impact on prices than under REE. Distribution of beliefs among agents can have a persistent effect on the long term price level volatility and, given that agents are risk averse and given the presence of endogenous uncertainty, in a RBE the wage rate is higher in expected value than would be forthcoming under REE. Under Rational Expectations monetary policy has no effect because agents neutralize such effect by predicting correctly the effect of the pol- icy. Under Rational Beliefs it is shown instead that price fluctuations and recessions can be substantially aggravated by the structure of beliefs.