Professional Documents
Culture Documents
Keynesian economists of the 1960s often appealed to the PHILLIPS CURVE, taking it to imply that monetary or fiscal policy that lowered the unemployment rate also caused a higher INFLATION rate. The interesting policy question was the trade-off: How much extra inflation was a one-point fall in the unemployment rate worth? The new classical rejected the idea that there was any useful trade-off. They argued that an expansion of aggregate demand lowered unemployment only because the acceleration in prices was not anticipated, that is, if monetary policy is unannounced, Firms that mistook higher market prices for higher real returns would be willing to produce more. Workers who mistook higher market wages for higher purchasing power would be willing, if unemployed, to take a job sooner. Increased output and lower unemployment would, however, be temporary and in short run because neither the returns to firms nor the purchasing power of workers was, corrected for inflation, really higher. As soon as they realized the mistake, firms and workers would return to old levels of production and labor supply. What is more, having made the mistake once, they would not be easily fooled again by the same policy. The combination of rational expectations and the central tenet of new classical analysis that quantity supplied equals quantity demanded ensure that systematic, pure aggregate-demand policies do not have real effects on the economy. The Phillips curve trade-off can be observed in the data because some part of policy is always unanticipated. But policymakers cannot exploit it because the public will see through any systematic policy. Because it rejected the prevailing Keynesian view that MONETARY POLICY could offset a recession, this policy-ineffectiveness proposition became the most startling and controversial conclusion of the early new classical macroeconomics. The above channel can be explained by fooling model.
P LA S
SAS2 SAS1
If policy is announced, both producers and workers have perfect information, so that they make expectations utilizing all prior and future information. Hence, there will be no effect on output and employment. This is the idea behind policy ineffectiveness. The Sargent Wallace work was important not because of its substantive results of policy ineffectiveness but because it helped familiarize macroeconomists with the use of rational expectations. So, we can conclude that new-classical are the same as classical in short run when policy is anticipated (policy is ineffective) and like monetarist when policy is unanticipated.
Criticism:
The Sargent and Wallace model has been criticized by a wide range of economists. There are those who doubt the validity of the assumption of rational expectations such as Milton Friedman. Sanford Grossman and Joseph Stiglitz argue that although agents have the cognitive ability to form rational expectations, they will be unable to profit from the resultant information since their actions will reveal to others the nature of this information. Agents therefore avoid the cost of obtaining the information and allow government policy to remain effective. The New Keynesian Stanley Fischer (1977) applied the insights of Franco Modigliani to the model employed by Sargent and Wallace. Fischer therefore introduced the assumption that workers sign nominal wage contracts that last for more than one period, wages are "sticky". The outcome is that government policy can be 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. It is not only possible for government policy to be used effectively but its use is also desirable. The government is able respond to random shocks to the economy to which agents are unable to react, and so stabilize output and employment. The BarroGordon model showed how the ability of government to manipulate output would lead to inflationary bias. 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 stabilization
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.
Reference:
http://alt-views.org/elearning.alt-views.org/a_main/uol/data/pip.pdf http://ideas.repec.org/p/nbr/nberwo/1114.html http://en.wikipedia.org/wiki/Policy_Ineffectiveness_Proposition http://www.econlib.org/library/Enc/NewClassicalMacroeconomics.html Mankiw, N Gregory (1990), A quick Refresher Course in Macroeconomics, Journal of Economic Literature, 28: 1645-1660.