Policy Ineffectiveness Proposition

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The Policy Ineffectiveness Proposition (PIP) is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations. It demonstrated that governments are powerless in the management of output and employment in an economy.

[edit] Theory

Prior to the work of Sargent and Wallace, macroeconomic models were largely based on the assumption of adaptive expectations. Many economists found this unsatisfactory since it assumes that agents will repeatedly make systematic errors and only revise their expectations in a backward looking nature. 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 money supply has occurred, and even then agents would only react 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 behaviour 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. 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 and prices remain constant and therefore so does output, no money illusion occurs. Only stochastic shocks to the economy can cause deviations in employment from its natural level.

The theory appeared to be a major blow to a substantial proportion of macroeconomics, particularly Keynesian economics. It produced the Lucas critique that such models were not fit for purpose. However, criticisms of the theory were quick to follow its publication.

[edit] Critique

The Sargent and Wallace model has been critised by a wide range of economists. There are those, such as Milton Friedman, who question the validity of the assumption of rational expectations. 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". 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 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. 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.

[edit] References

  • Barro, Robert J. 1977. Unanticipated Money Growth and Unemployment in the United States. The American Economic Review 67, no. 2 (March): 101-115
  • Barro, Robert J. 1978. Unanticipated Money, Output, and the Price Level in the United States. The Journal of Political Economy 86, no. 4 (August): 549-580
  • Sargent, Thomas, and Neil Wallace. 1976. Rational Expectations and the Theory of Economic Policy. Journal of Monetary Economics 2, no. 2 (April): 169-183
  • Glick, Reuven, and Michael Hutchison. 1990. New Results in Support of the Fiscal Policy Ineffectiveness Proposition. Journal of Money, Credit, and Banking 22, no. 3 (August): 288-304
  • Grossman, Sanford J. and Stiglitz, Joseph, 1980. "On the Impossibility of Informationally Efficient Markets". American Economic Review 70 (3): 393–408.
  • Heijdra, Ben J. and van der Ploeg, F. 2002. Foundations of Modern Macroeconomics
  • McCallum, Bennett T. 1979. The Current State of the Policy-Ineffectiveness Debate. The American Economic Review 69, no. 2 (May): 240-245
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