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the discretion of policymakers and commit them to a rule of never negotiating. If policymakers were truly unable to make concessions, the incentives for terrorists to take hostages would be largely eliminated.

The same problem arises less dramatically in the conduct of monetary policy. Consider the dilemma of a Federal Reserve that cares about both inflation and unemployment. According to the Phillips curve, the trade-off between inflation and unemployment depends on expected inflation. The Fed would prefer everyone to expect low inflation so that it will face a favourable trade-off. To reduce expected inflation, the Fed often announces that low inflation is the paramount goal of monetary policy.

But an announcement of a policy of low inflation is by itself not credible. Once expectations are formed, the Fed has an incentive to renege on its announcement in order to reduce unemployment. Private economic actors understand the incentive to renege and therefore do not believe the announcement in the first place. Just a president facing a hostage crisis is sorely tempted to negotiate their release, a Federal Reserve with discretion is sorely tempted to inflate in order to reduce unemployment. And just as terrorists discount announced policies of never negotiating, private economic actors discount announced policies of low inflation.

The surprising implication of this analysis is that policymakers can sometimes better achieve their goals by having their discretion taken away from them. In the case of rational terrorists, there will be fewer hostages taken and fewer hostages killed if policymakers are committed to following the seemingly harsh rule of refusing to negotiate for hostages’ freedom. In the case of monetary policy, there will be lower inflation without higher unemployment if the Fed is committed to a policy of zero inflation.

Actually, in real business cycle models, intervention is unnecessary because the economy is assumed to be always able to operate efficiently at full employment. Monetary shocks are dismissed as a source of variation in input (Kydland and Prescott, 1982). As we have seen above, the economy’s fluctuations are due to external real shocks (shifts in the economy’s underlying productivity). It is assumed that markets adjust quickly and in less time than it would take for government to act, well and truly. Since the economy is at full employment,

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government needs worry only about keeping inflation low and stable. The central bank just needs to set a low target for inflation.

More generally, in the New Classical theory (as the rational expectations theory), the government cannot affect output even in the short run. Contrary to

Phillips curve’s story, New Classical approach argues that inflation can be reduced without leading to higher unemployment. By reducing its inflation target, the monetary authority shifts the aggregate demand-inflation curve to the right. If agents are convinced that the inflation target has been reduced, they will adjust their wage and price behaviour, and lower inflation is achieved at no cost. In the

Lucas’s vein (1972), the New Classical economists (under the rational expectations hypothesis) argue that predictable and systematic monetary policies are largely ineffective in influencing real output and employment (Sargent and Wallace, 1975).

The main foundation of these approaches is the neo-walrasian framework of a real equilibrium economy. This holds the spontaneous market mechanisms sacred and efficient. So the money is neutral or should be neutralized by avoiding the interventions of monetary authorities. Even when it is sometimes admitted that government policies could affect the economy because of some shortcomings in markets, this approach is a paradigm of no confidence in the government’s ability to improve market’s performance and it considers interventions as counterproductive.

The first argument of this so-called counter-productivity is founded on the fact that it takes time for authorities to recognize a problem (lags in getting data, conflicting information implying uncertainty on the very state of the economy, etc.) and to act really. It is also remarked that there can be time lags between when a policy action is taken and when it has an impact on the economy. Moreover, agents, including monetary authorities, see the future throughout a cloudy sky. Therefore, lags make that the action may no longer be appropriate by the time its effects are fully realized.

The second argument assumes that government, before election, may increase public expenditures to overheat the economy in order to win gains in employment but incurring costs, in terms of higher inflation. That seems to be one

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of the reasons for which one can attempt to reduce the influence of elected politicians on monetary policy.

Whether because of politically motivated actions or because of the lags described above, government’s monetary actions are supposed to exacerbate the fluctuation. Critics, following Milton Friedman, conclude that better policies would result if government actions were based on simple rules rather than on the discretion of the monetary authorities. As long as the markets are supposed to contain spontaneous equilibrating mechanisms, no active monetary policy is necessary.

To keep the economy in an efficient path, the advocates of the noninterventionism put forward that the government faces the temptation of not carrying out promised actions when it announces its future monetary policies. Knowing this, individuals will not believe the initial promise to be steadfast; they will expect higher inflation in the future. Lack of credible commitments to a low inflation policy may result in anticipation of higher inflation which would increase current inflation too. The government’s attempt to maximize the revenue from money creation generates the lack of confidence and, thus, a time inconsistency.

Therefore, the inflation targeting as a framework for carrying out monetary policy is suggested as a relevant way of establishing a reputation effect which can discipline the policymakers’ actions and push them to fulfil their promises, avoiding the dynamic inconsistency and the monetary shocks on markets. Inflation targeting involves the central bank to publicly define its policy goals in terms of keeping inflation rate low. A formal target is supposed to enhance the credibility of monetary policy announcements and to promote continuity in policy which would also serve to reduce the uncertainty about government actions. Adopting a formal inflation target becomes the way by which the monetary policy can be neutralized and the markets can evolve without external disturbances. The goal of low and stable inflation translates the goal of stable prices and the independence is seen as an appropriate way of separating a technical obligation (exogeneity and neutrality of money and the monetary character of the inflation) and the political duties (satisfying electoral obligations).

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3. 2. Rules for Monetary Policy

Even if we are convinced that policy rules are superior to discretion, the debate over macroeconomic policy is not over. If the central bank were to commit a rule for monetary policy, what rule should it choose? Let’s discuss briefly three policy rules that various economists advocate.

Monetarist economists (for instance, M. Friedman) advocate that the central bank keep the money supply growing at a steady rate. Monetarists believe that fluctuations in the money supply are responsible for most large fluctuations in the economy. They argue that slow and steady growth in the money supply would yield stable output, employment and prices.

Although a monetarist policy rule might have prevented many of the economic fluctuations we have experienced historically, most economists believe that it is not the best possible policy rule. Steady growth in the money supply stabilizes aggregate demand only if the velocity of money is stable. But the large fall in velocity in the early 1980s shows that velocity is sometimes unstable. Most economists believe that a policy rule needs to allow the money supply to adjust to various shocks to the economy.

A second policy rule that economists widely advocate is a nominal GDP target. Under this rule, the central bank announces a planned path for nominal GDP. If nominal GDP rises above the target, the central bank reduces money growth to dampen aggregate demand. If it falls below the target, the central bank raises money growth to stimulate aggregate demand. Since a nominal GDP target allows monetary policy to adjust to changes in the velocity of money, most economists believe it would lead to greater stability in output and prices than a monetarist policy rule.

A third policy rule that is often advocated is a target for the price level. Under this rule, the central bank announces a planned path for the price level and adjusts the money supply when the actual price level deviates from the target. Proponents of this rule usually believe that price stability should be the primary goal of monetary policy.

Notice that all these rules are expressed in terms of some nominal variablethe money supply, nominal GDP, or the price level. One can also imagine policy

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rules expressed in terms of real variables. For example, the central bank might try to target the unemployment rate at 5 percent. The problem with such a rule is that no one knows exactly what the natural rate of unemployment. If the central bank chose a target for the unemployment rate below the natural rate, the result would be accelerating inflation. Conversely, if the central bank chose a target for the unemployment rate below the natural rate, the result would be accelerating deflation. For this reason, economists rarely advocate rules for monetary policy expressed solely in terms of real variables, even though real variables such as unemployment and real GDP are the best measures of economic performance.

3. 3. Rules for Fiscal Policy

Although most discussion of policy rules centres on monetary policy, economists and politicians also frequently propose rules for fiscal policy. The rule that has received the most attention is the balanced-budget rule. Under a balanced-budget rule, the government would not be allowed to spend more than it receives in tax revenue. In the United States, many state governments operate under such a fiscal policy rule, since state constitutions often require a balanced budget. A recurring topic of political debate is whether the federal constitution should require a balanced budget for the federal government.

Most economists oppose a strict rule requiring the government to balance its budget. Three considerations lead them to believe that a budget deficit or surplus is sometimes appropriate.

First, a budget deficit or surplus can help stabilize the economy. In essence, a balanced-budget rule would revoke the automatic stabilizing powers of the system of taxes and transfers. When the economy goes into a recession, taxes automatically fall, and transfers automatically rise. While these automatic responses help stabilize the economy, they push the budget into deficit. A strict balanced-budget rule would require that the government raise taxes or reduce spending in a recession, which would further depress aggregate demand.

Second, a budget deficit or surplus can be used to minimize the distortion of incentives caused by the tax system. High tax rates impose a cost on society by discouraging economic activity. The higher the tax rates, the greater the social cost of taxes. The total social cost of taxes is minimized by keeping tax rates

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relatively stable, rather than making them high in some years and low in others. Economists call this policy tax smoothing. To keep tax rates smooth, a deficit is necessary in years of unusually low income (recession) and unusually high expenditures (wars).

Third, a budget deficit can be used to shift a tax burden from current to future generations. For example, some economists argue that if the current generation fights a war to maintain freedom, future generations benefit. To make the future beneficiaries pay some of the costs, the current generation can finance the war with a budget deficit. The government can retire the debt issued during the war by levying taxes on the next generation.

The considerations lead most economists to reject a strict balanced-budget rule. At the very least, a rule for fiscal policy needs to take account of the recurring episodes, such as recessions and wars, during which a budget deficit is a reasonable policy response.

3. 4. Uncertainty and Difficulties

We have examined whether policy should take an active or passive role in responding to economic fluctuations and whether policy should be conducted by rule or by discretion. There are many arguments on both sides of these questions. Perhaps the only clear conclusion is that there is no simple and compelling case for any particular view of macroeconomic policy.

Economists play a key role in the formulation of economic policy. Because the economy is complex, this role is often difficult. Yet it is also inevitable. In the meantime, someone must advice economic policymakers. That job, difficult as it sometimes is, falls to economists. The role of economists in the policymaking process goes beyond the giving advice to policymakers. Even economists cloistered in academia influence policy indirectly through their research and writing. In the conclusion of The General Theory, John Maynard Keynes wrote that

“…the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their

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frenzy from some academic scribbler of a few years back”. This is as true today as it was when Keynes wrote it in 1935-except now that academic scribbler is often Keynes himself.

4. New Keynesian economics

Economists do not agree on the best way to explain short-run economic fluctuations. There are two major schools of thought: new classical economics and new Keynesian economics.

New classical economists advocate models in which wages and prices adjust quickly to clear markets. The market-clearing models examined in the chapter-the worker-misperception and imperfect-information models-were popular among new classical economists in the 1970s. More recently, many new classical economists have turned their attention to real-business-cycle theory, which applies the tenets of the classical model-price flexibility and monetary neutrality-to explain economic fluctuations.

New Keynesian economists believe that the market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with sticky wages and prices. In The General Theory, Keynes urged economists to abandon the classical presumption that wages and prices adjust quickly to equilibrate markets. He emphasized that aggregate demand is a primary determinant of national income in the short run. New Keynesian economists accept these basic conclusions.

In their research, New Keynesian economists try to develop more fully the Keynesian approach to economic fluctuations. Much New Keynesian research is aimed at refining the theory of aggregate supply by explaining how wages and prices behave in the short run. This work tries to identify more precisely the market imperfections that make wages and prices sticky and that cause the economy to return only slowly to the natural rate. In this section we discuss some of these recent developments.

4. 1. Small Menu Costs and Aggregate-Demand Externalities

One reason that prices do not adjust immediately in the short run is that there are costs involved in adjusting prices. To change its prices, a firm may need to send out a new catalogue to customers, distribute new price lists to its sales

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staff, or, in the case of a restaurant, print new menus. These costs of price adjustment, called menu costs, lead firms to adjust prices intermittently rather than continuously.

Economists disagree about whether menu costs explain the short-run stickiness of prices. Sceptics point out that menu costs are usually very small. How can small menu costs help to explain recession, which are very costly for society? Proponents reply that small does not mean inconsequential: even though menu costs are small for the individual firm, they can have large effects on the economy as a whole.

According to proponents of the menu-costs hypothesis, to understand why prices adjust slowly, we must acknowledge that there are externalities to price adjustment: a price reduction by one firm benefits other firms in the economy. When a firm lowers the price it charges, it slightly lowers the average price level and thereby raises real money balances. The increase in real money balances expands aggregate income. The economic expansion in turn raises the demand for the products of all firms. This macroeconomic impact of one firm’s price adjustment on the demand for all other firms’ product is called an aggregatedemand externality.

In the presence of this aggregate-demand externality, small menu costs can make prices sticky, and this stickiness can have a large cost to society. Suppose that a firm originally sets its price too high and later must decide whether to cut its price. Because of the aggregate-demand externality, the benefit to society of the price cut would exceed the benefit to the firm. Because the firm ignores this externality when making its decision, it sometimes fails to pay the menu cost and cut its price even though the price cut is socially desirable. Hence, sticky prices may be optimal for those setting prices, even though they are undesirable for the economy as a whole.

4. 2. The Staggering of Wages and Prices

Not everyone in the economy sets new wages and prices at the same time. Instead, the adjustment of wages and prices throughout the economy is staggered. Staggering makes the overall level of wages and prices adjust slowly, even when individual wages and prices change frequently.

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Consider the following example. Suppose first that price setting is synchronized: every firm adjusts its price on the first day of every month. If the money supply and aggregate demand rise on May 10, output will be higher from May 10 to June 1 because prices are fixed during this interval. But on June 1 all firms will raise their prices in response to the higher demand, ending the boom.

Now suppose that price setting is staggered: half the firms set prices on the first of each month and half on the fifteenth. In the money supply rises on May 10, then half the firms can raise their prices on May 15. But these firms will probably not raise their prices very much. Because half the firms will not be changing their prices on the fifteenth, a price increase by any firm will raise that firm’s relative price, which will cause it to lose customers. (In contrast, if all firms are synchronized, all firms can raise prices together, leaving relative prices unaffected.) If the May 15 price-setters make little adjustment in their prices, then the other firms will make little adjustment when their turn comes on June 1, because they also want to avoid relative price changes. And so on. The price level rises slowly as the result of small price increases on the first and the fifteenth of each month. Hence, staggering makes the price level sluggish, because no firm wishes to be the first to post a substantial price increase.

Staggering also affect wage determination. Consider, for example, how a fall in the money supply works its way through the economy. A smaller money supply implies reduced aggregate demand, which in turn requires a proportionate fall in nominal wages to maintain full employment. Each worker might be willing to take a cut in his nominal wage if all other wages were to fall proportionately. But each worker is reluctant to be the first to take a pay cut, knowing that this means, at least temporarily, a fall in his relative wage. Since the setting of wages staggered, the reluctance of each worker to reduce this wage first makes the overall level of wages slow to respond to changes in aggregate demand. In other words, the staggered setting of individual wages makes the overall level of wages sticky.

4. 3. Recession as a Coordination Failure

Some New Keynesian economists suggest that recession result from a failure of coordination. In recessions, output is low, workers are unemployed, and

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factories sit idle. It is possible to imagine allocations of resources in which everyone is better off-for example, the high output and unemployment of the 1920s is clearly preferable to the low output and unemployment of the 1930s. If society fails to reach an outcome that is feasible and that everyone prefers, then the members of society have failed to coordinate in some way.

Coordination problems can arise in the setting of wages and prices because those who set them must anticipate the actions of other wage price setters. Union leaders negotiating wages are concerned about the concessions other unions will win. Firms setting prices are mindful of the prices other firms will charge.

To see how a recession could arise as a failure of coordination, consider the following parable, called the prisoner’s dilemma. The economy is made up of two firms. After a fall in the money supply, each firm must decide whether to cut its price. Each firm wants to maximize its profit, but its profit depends not only on its pricing decision, but also on the decision made by other firm:

The choices facing each firm are listed in the above figure which shows how the profits of the two firms depend on their actions. If neither firm cuts its price, real money balances are low, a recession ensues, and each firm makes a profit of only $15. If both firms cut their prices, real money balances are high, a recession is avoided, and each firm makes a profit of $30. If one firm cuts its price while the

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