In this paper I use some recent work in the microeconomics of imperfect information to construct a macro model. The microeconomic theory suggests that atomistically competitive firms face kinked demand curves. In this model there is a range of aggregate equilibria consistent with correct information. I then show that individual firms can face a free-rider problem in trying to move from one equilibrium to another by changing the price level. Monetary policy is not subject to this problem, even if the policy is fully anticipated.

I. Rational expectations and the optimal monetary instrument, 92.—II. The Fed's advantage in stabilizing the economy when the private sector has the same information, 96.—III. Information differences between the Fed and the private sector, 98.—IV. Conclusions, 101.

generous referee; remaining errors are my own. The exact finite sample distribution for the two-stage least square estimator has been derived for quite general situations (see Phillips (1983) for a survey of the literature). Unfortunately, these general expressions do not lend themselves to easy interpretations. Consequently, a number of authors have looked at special cases to illustrate some of the problems that can arise when using asymptotic distribution results for finite samples. Two such special cases of note are: 1) The totally unidentified case, where the population covariance between the instruments and the endogenous variable is zero; 2) The very weakly correlated case (first stage R2 much less than the inverse of the sample size) with one equation and one endogenous regressor. Nelson and Startz ’ (1990a&b) pioneered the study of the very weakly correlated case. Their work dramatized the substantial differences that can arise between the exact distribution of the IV estimator and the asymptotic distribution. They argue that: 1) the IV estimate will be concentrated around a value more biased than the plim of the OLS estimate and the ratio of the two biases falls as the correlation between the endogenous variable and

Dale Henderson and Thomas Sargent (hereafter H-S) and Y. C. Park have analyzed the effectiveness of monetary and fiscal policy in the two-sector analogue of James Tobin's dynamic aggregative model. Contrary to the assumptions of Tobin's model, fiscal policy can affect real income in the H-S model. However, the sign of the effect of fiscal policy on real income depends on a number of conditions relating to the parameters of the money demand function and the capital intensities in the two sectors. A somewhat more disturbing result is that the sign of the effect of fiscal policy changes as one changes, ceteris paribus, the assumption of which sector is the more capital intensive. The H-S results seem to imply that the analysis of the effectiveness of fiscal policy in the traditional ISLM analysis is very sensitive to the assumption of a one-sector production technology. It is important to realize, however, that the H-S model differs from IS-LM analysis in two ways. Besides assuming a two-sector production technology, the H-S model also assumes a perfect capital market, where the asset value of capital is always equal to reproduction cost. Sargent and Neil Wallace have analyzed a one-sector model with and without the perfect capital market assumption (without and with a disequilibrium investment demand function). They find that many of the strange results of Tobin's model are eliminated if there are costs of adjusting the capital stock. For example, if the costs of adjustment are large enough, expansionary monetary policy lowers the interest rate as in IS-LM analysis, contrary to Tobin's results. Also, the stability conditions of the model imply that with costs of adjusting the capital stock, fiscal policy affects income and interest rates in much the same way as in IS-LM analysis. This paper alters the H-S model to allow for an investment demand function based on costs of adjustment.' In analyzing the comparative static results of this model one can determine whether the strange results of the H-S model are due to the assumption of a two-sector production technology or the assumption of a perfect market in existing capital goods. The profit-maximizing subsystem in the H-S model can be solved to yield the price level and the marginal product of capital as functions of the relative price of investment (see the Appendix). A general equilibrium occurs when the consumption good, money,2 and investment good markets are in equilibrium.

[The continuous version of the end-of-period equilibrium specification is shown to exist when there is a sequence of temporary equilibria. This is also a sufficient condition for the continuous versions of the beginning-of-period and end-of-period specifications to be equivalent. This refutes Foley's contention that perfect foresight is a necessary condition for these results.]