Under the traditional interpretation of macroeconomic fluctuations, aggregate demand shocks move output and prices in the same direction, while aggregate supply shocks move output and prices in opposite directions. This paper examines the joint behavior of U.S. output, unemployment, prices, wages, and nominal money and asks whether it is consistent with this interpretation. The answer is a qualified yes.

[Explaining economic fluctuations by the existence of imperfect wage rules begs the question of why such rules are chosen in labor contracts. The form of wage rules is not exogenous but determined by cost and efficiency considerations. Fully contingent rules preserve efficiency but are costly to write and enforce. Noncontingent rules may lead to large inefficiencies. Actual rules, which index the wage only to the price level, may be the optimal compromise. This paper characterizes the equilibrium of an economy in which the form of wage rules is endogenous. It shows the effects of the distributions of exogenous shocks on the equilibrium distribution of output and the form of the rule. It then studies the role of policy in such an economy.]

We interpret fluctuations in GNP and unemployment as due to two types of disturbances: disturbances that have a permanent effect on output and disturbances that do not. We interpret the first as supply disturbances, the second as demand disturbances. Demand disturbances have a hump-shaped mirror-image effect on output and unemployment. The effect of supply disturbances on output increases steadily over time, peaking after two years and reaching a plateau after five years.

How important is monopolistic competition to an understanding of the effects of aggregate demand on output? We ask the question at three levels. Can monopolistic competition, by itself, explain why aggregate demand movements affect output? Can it, together with other imperfections, generate effects of aggregate demand in a way that perfect competition cannot? If so, can it give an accurate account of the response of the economy to aggregate demand movements? The answers are no, yes, and yes.

Explaining economic fluctuations by the existence of imperfect wage rules begs the question of why such rules are chosen in labor contracts. The form of wage rules is not exogenous but determined by cost and efficiency considerations. Fully contingent rules preserve efficiency but are costly to write and enforce. Noncontingent rules may lead to large inefficiencies. Actual rules, which index the wage only to the price level, may be the optimal compromise. This paper characterizes the equilibrium of an economy in which the form of wage rules is endogenous. It shows the effects of the distributions of exogenous shocks on the equilibrium distribution of output and the form of the rule. It then studies the role of policy in such an economy.

IN HIS SURVEY ON RATIONAL EXPECTATIONS, R. Shiller indicates that the difficulty of obtaining explicit solutions for linear difference models under rational expectations may have hindered their use [14, p. 27]. The present paper attempts to remedy that problem by giving the explicit solution for an important subclass of the model Shiller refers to as the general linear difference model. Section 1 presents the form of the model for which the solution is derived and shows how particular models can be put in this form. Section 2 gives the solution together with the conditions for existence and uniqueness. 1. THE MODEL The model is given by (la), (lb), and (1c) as follows: