The Reeded Edge and the Phillips Curve: Money Neutrality, Common Knowledge, and Subjective Beliefs☆
Abstract I present a simple two-person auction model in which a seller and a buyer make bids in terms of money; however, the value of a unit of money is uncertain. I show: (1) a monetary revaluation has purely nominal effects if and only if it is common knowledge; (2) if seller and buyer have identical beliefs, making the value of money common knowledge maximizes total gains from trade; (3) if seller and buyer are equally well informed and have identical beliefs, then monetary revaluations have no net effect; (4) when the seller knows the value of money but the buyer does not, the expected utilities of both seller and buyer are proportional to 1/(1+ σ 2 ), where σ is the standard deviation of the value of money expressed as a fraction of the mean; and (5) when beliefs are subjective, monetary policy can improve total gains from trade, as in Friedman's explanation of the Phillips curve, and an optimal level of inflation can be determined. Journal of Economic Literature Classification Numbers: C78, E52.