Endogenous Uncertainty and the Non-neutrality of Money

We study some implications of the Theory of Rational Beliefs to monetary\r\npolicy. We show that monetary policy in a Rational Beliefs environment can\r\nhave an important effect on the characteristics of economic fluctuations. In Rational\r\nBeliefs Equilibria money is generically non-neutral unlike Rational Expectations\r\nEquilibria in which money is neutral and monetary policy is ineffective. Under\r\nRational Beliefs Equilibria nominal prices and real output change not only in response\r\nto changes in the exogenous growth rate of money but also in response to\r\nchanges in the state of beliefs. In Rational Beliefs Equilibria monetary shocks have\r\nreal effects even when they are observed but are not fully anticipated. Furthermore,\r\nthe non-neutrality of money results in a short run Phillips curve. When money\r\n¿flutters, real output sputters¿. We show that Endogenous Uncertainty and the\r\ndistribution of market beliefs are the major explanatory variables of such fluctuations.\r\nUnder Rational Expectations monetary policy is ineffective because agents\r\nneutralize it by predicting correctly the effect of the policy. Under Rational Beliefs\r\nit is shown instead that inflation and recessions can be substantially aggravated by\r\nthe distribution of market beliefs.