Policy-ineffectiveness proposition

Last updated

The policy-ineffectiveness proposition (PIP) is a new classical theory proposed in 1975 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations, which posits that monetary policy cannot systematically manage the levels of output and employment in the economy.

Contents

Theory

Prior to the work of Sargent and Wallace, macroeconomic models were largely based on the adaptive expectations assumption. Many economists found this unsatisfactory since it assumes that agents may repeatedly make systematic errors and can only revise their expectations in a backward-looking way. Under adaptive expectations, agents do not revise their expectations even if the government announces a policy that involves increasing money supply beyond its expected growth level. Revisions would only be made after the increase in the money supply has occurred, and even then agents would react only gradually. In each period that agents found their expectations of inflation to be wrong, a certain proportion of agents' forecasting error would be incorporated into their initial expectations. Therefore, equilibrium in the economy would only be converged upon and never reached. The government would be able to maintain employment above its natural level and easily manipulate the economy.

This behavior by agents is contrary to that which is assumed by much of economics. Economics has firm foundations in assumption of rationality, so the systematic errors made by agents in macroeconomic theory were considered unsatisfactory by Sargent and Wallace. More importantly, this behavior seemed inconsistent with the stagflation of the 1970s, when high inflation coincided with high unemployment, and attempts by policymakers to actively manage the economy in a Keynesian manner were largely counterproductive. When applying rational expectations within a macroeconomic framework, Sargent and Wallace produced the policy-ineffectiveness proposition, according to which the government could not successfully intervene in the economy if attempting to manipulate output. If the government employed monetary expansion in order to increase output, agents would foresee the effects, and wage and price expectations would be revised upwards accordingly. Real wages would remain constant and therefore so would output; no money illusion occurs. Only stochastic shocks to the economy can cause deviations in employment from its natural level.

Taken at face value, the theory appeared to be a major blow to a substantial proportion of macroeconomics, particularly Keynesian economics. However, criticisms of the theory were quick to follow its publication.

Criticisms

The Sargent and Wallace model has been criticised by a wide range of economists. Some, like Milton Friedman,[ citation needed ] have questioned the validity of the rational expectations assumption. Sanford Grossman and Joseph Stiglitz argued that even if agents had the cognitive ability to form rational expectations, they would be unable to profit from the resultant information since their actions would then reveal their information to others. Therefore, agents would not expend the effort or money required to become informed and government policy would remain effective.

The New Keynesian economists Stanley Fischer (1977) and Edmund Phelps and John B. Taylor (1977) assumed that workers sign nominal wage contracts that last for more than one period, making wages "sticky". With this assumption the model shows government policy is fully effective since, although workers rationally expect the outcome of a change in policy, they are unable to respond to it as they are locked into expectations formed when they signed their wage contract. Not only is it possible for government policy to be used effectively, but its use is also desirable. The government is able to respond to stochastic shocks in the economy which agents are unable to react to, and so stabilise output and employment.

The Barro–Gordon model showed how the ability of government to manipulate output would lead to inflationary bias. [1] The government would be able to cheat agents and force unemployment below its natural level but would not wish to do so. The role of government would therefore be limited to output stabilisation.

Since it was possible to incorporate the rational expectations hypothesis into macroeconomic models whilst avoiding the stark conclusions that Sargent and Wallace reached, the policy-ineffectiveness proposition has had less of a lasting impact on macroeconomic reality than first may have been expected. In fact, Sargent himself admitted that macroeconomic policy could have nontrivial effects, even under the rational expectations assumption, in the preface to the 1987 edition of his textbook Dynamic Macroeconomic Theory:

'The first edition appeared at a time when discussions of the 'policy-ineffectiveness proposition' occupied much of the attention of macroeconomists. As work of John B. Taylor has made clear, the methodological and computational implications of the hypothesis of rational expectations for the theory of optimal macroeconomic policy far transcend the question of whether we accept or reject particular models embodying particular neutrality propositions... The current edition contains many more examples of models in which a government faces a nontrivial policy choice than did the earlier edition.'

Despite the criticisms, Anatole Kaletsky has described Sargent and Wallace's proposition as a significant contributor to the displacement of Keynesianism from its role as the leading economic theory guiding the governments of advanced nations. [2]

Reception

While the policy-ineffectiveness proposition has been debated, its validity can be defended on methodological grounds. To do so, one has to realize its conditional character. For new classicals, countercyclical stimulation of aggregate demand through monetary policy instruments is neither possible nor beneficial if the assumptions of the theory hold. If expectations are rational and if markets are characterized by completely flexible nominal quantities and if shocks are unforeseeable white noises, then macroeconomic systems can deviate from the equilibrium level only under contingencies (i.e. random shocks). However, no systematic countercyclical monetary policy can be built on these conditions, since even monetary policy makers cannot foresee these shocks hitting economies, so no planned response is possible. [3] According to the common and traditional judgement, new classical macroeconomics brought the inefficiency of economic policy into the limelight. Moreover, these statements are always undermined by the fact that new classical assumptions are too far from life-world conditions to plausibly underlie the theorems. [4] So, it has to be realized that the precise design of the assumptions underlying the policy-ineffectiveness proposition makes the most influential, though highly ignored and misunderstood, scientific development of new classical macroeconomics. New classicals did not assert simply that activist economic policy (in a narrow sense: monetary policy) is ineffective. Robert Lucas and his followers drew the attention to the conditions under which this inefficiency probably emerges. [5]

See also

Related Research Articles

In economics, adaptive expectations is a hypothesized process by which people form their expectations about what will happen in the future based on what has happened in the past. For example, if inflation has been higher than expected in the past, people would revise expectations for the future.

Macroeconomics branch of economics that studies aggregated indicators

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.

In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid. Rational expectations ensure internal consistency in models involving uncertainty. To obtain consistency within a model, the predictions of future values of economically relevant variables from the model are assumed to be the same as that of the decision-makers in the model, given their information set, the nature of the random processes involved, and model structure. The rational expectations assumption is used especially in many contemporary macroeconomic models.

New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

This aims to be a complete article list of economics topics:

The Ricardian equivalence proposition is an economic hypothesis holding that consumers are forward looking and so internalize the government's budget constraint when making their consumption decisions. This leads to the result that, for a given pattern of government spending, the method of financing that spending does not affect agents' consumption decisions, and thus, it does not change aggregate demand.

Neo-Keynesian economics is a school of macroeconomic thought that was developed in the post-war period from the writings of John Maynard Keynes. A group of economists, attempted to interpret and formalize Keynes' writings and to synthesize it with the neoclassical models of economics. Their work has become known as the neoclassical synthesis and created the models that formed the core ideas of neo-Keynesian economics. These ideas dominated mainstream economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 1960s and 1970s.

A macroeconomic model is an analytical tool designed to describe the operation of the problems of economy of a country or a region. These models are usually designed to examine the comparative statics and dynamics of aggregate quantities such as the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the level of prices.

Robert Joseph Barro is an American macroeconomist and the Paul M. Warburg Professor of Economics at Harvard University. The Research Papers in Economics project ranked him as the fifth most influential economist in the world, as of March 2016, based on his academic contributions. Barro is considered one of the founders of new classical macroeconomics, along with Robert Lucas, Jr. and Thomas J. Sargent. He is currently a senior fellow at Stanford University's Hoover Institution and co-editor of the Quarterly Journal of Economics, the top journal in economics in terms of its impact factor.

John B. Taylor Mary and Robert Raymond Professor of Economics at Stanford University

John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution.

Thomas J. Sargent American economist

Thomas John "Tom" Sargent is an American economist, who is currently the W.R. Berkley Professor of Economics and Business at New York University. He specializes in the fields of macroeconomics, monetary economics and time series econometrics. As of 2014, he ranks fourteenth among the most cited economists in the world. He was awarded the Nobel Memorial Prize in Economics in 2011 together with Christopher A. Sims for their "empirical research on cause and effect in the macroeconomy".

In macroeconomics, the classical dichotomy is the idea, attributed to classical and pre-Keynesian economics, that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables such as output and real interest rates can be completely analyzed without considering what is happening to their nominal counterparts, the money value of output and the interest rate. In particular, this means that real GDP and other real variables can be determined without knowing the level of the nominal money supply or the rate of inflation. An economy exhibits the classical dichotomy if money is neutral, affecting only the price level, not real variables.

The Lucas islands model is an economic model of the link between money supply and price and output changes in a simplified economy using rational expectations. It delivered a new classical explanation of the Phillips curve relationship between unemployment and inflation. The model was formulated by Robert Lucas, Jr. in a series of papers in the 1970s.

Phillip David Cagan was an American scholar and author. He was Professor of Economics Emeritus at Columbia University.

New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.

History of macroeconomic thought Wikimedia history article

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

Neil Wallace is an American economist and professor at Pennsylvania State University. Wallace is considered one of the main proponents of new classical macroeconomics.

The Lucas aggregate supply function or Lucas "surprise" supply function, based on the Lucas imperfect information model, is a representation of aggregate supply based on the work of new classical economist Robert Lucas. The model states that economic output is a function of money or price "surprise". The model accounts for the empirically based trade off between output and prices represented by the Phillips curve, but the function breaks from the Phillips curve since only unanticipated price level changes lead to changes in output. The model accounts for empirically observed short-run correlations between output and prices, but maintains the neutrality of money in the long-run. The policy ineffectiveness proposition extends the model by arguing that, since people with rational expectations cannot be systematically surprised by monetary policy, monetary policy cannot be used to systematically influence the economy.

The new neoclassical synthesis (NNS) or new synthesis is the fusion of the major, modern macroeconomic schools of thought, new classical and New-Keynesianism, into a consensus on the best way to explain short-run fluctuations in the economy. This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. The new synthesis provides the theoretical foundation for much of contemporary mainstream economics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.

The Taylor contract or staggered contract was first formulated by John B. Taylor in his two articles, in 1979 "Staggered wage setting in a macro model'. and in 1980 "Aggregate Dynamics and Staggered Contracts". In its simplest form, one can think of two equal sized unions who set wages in an industry. Each period, one of the unions sets the nominal wage for two periods. This means that in any one period, only one of the unions can reset its wage and react to events that have just happened. When the union sets its wage, it sets it for a known and fixed period of time. Whilst it will know what is happening in the first period when it sets the new wage, it will have to form expectations about the factors in the second period that determine the optimal wage to set. Although the model was first used to model wage setting, in new Keynesian models that followed it was also used to model price-setting by firms.

References

  1. ↑ Barro, Robert J.; Gordon, David B. (1983). "A Positive Theory of Monetary Policy in a Natural-Rate Model" (PDF). Journal of Political Economy . 91 (4): 589–610. doi:10.1086/261167.
  2. ↑ Anatole Kaletsky (2011). Capitalism 4.0: The Birth of a New Economy. Bloomsbury. p. 173. ISBN   978-1-4088-0973-0.
  3. ↑ Barro, Robert J. (1977). "Unanticipated money growth and unemployment in the United States". American Economic Review. 67 (2): 101–115.
  4. ↑ Weeks, John (1989). A critique of neoclassical macroeconomics. London: Macmillan.
  5. ↑ Galbács, Peter (2015). The Theory of New Classical Macroeconomics. Contributions to Economics. Heidelberg/New York/Dordrecht/London: Springer. p. 221. doi:10.1007/978-3-319-17578-2. ISBN   978-3-319-17578-2.

Further reading

This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.