Introduction

This part of the book is based on the notion that individuals do not have perfect current information on the general price level. They have timely information on prices in their own markets but are unable to distinguish perfectly between price changes that are caused by adjustments in the general price level and changes that reflect adjustments in relative prices. This is because individuals have current access to only the price in their own market. The representative individual thus observes only one component of the vector of current prices in the economy. Because this component is correlated in equilibrium with the general price level, it conveys information about the current general price level. The information conveyed is not exact, however, because the general price level and individual prices are not perfectly correlated. As a result, no individual in the economy knows the current general price level with certainty, and movements in the aggregate price level are to some extent confused with relative price changes.

We refer to this as the aggregate–relative confusion. The informational setup that characterizes the aggregate–relative confusion can be viewed as a particular instance of asymmetric information in economics: Different individuals have different information sets.

The notion of asymmetric information in the form of different information sets for different individuals has been used extensively in the microeconomic and finance literature. In particular, the asymmetric possession of information about characteristics of certain nonhomogeneous goods (such as labor) by the buyers and sellers of these goods is the basis for the signaling and screening literature.