Snowdon & Vane Modern Macroeconomics

Thus, in the Lucas model business cycles are generated by exogenous monetary demand shocks that transmit imperfect price signals to economic agents who, in a world of imperfect information, respond to price increases by increasing supply. The greater is the general price variability (the lower the variation in price attributed to relative price variation), the lower will be the cyclical response of output to a monetary disturbance, and vice versa. A major policy implication of the MEBCT is that a benign monetary policy would eliminate a large source of aggregate instability. Thus new classical economists come down on the side of rules in the ‘rules versus discretion’ debate over the conduct of stabilization policy.

We now turn to consider the main policy implications of the new classical approach to macroeconomics in more detail.

5.5The Policy Implications of the New Classical Approach

The combination of the rational expectations, continuous market-clearing and aggregate supply hypotheses produces a number of important policy conclusions. In what follows we discuss the main policy implications of the new classical approach, namely (i) the policy ineffectiveness proposition; (ii) the output–employment costs of reducing inflation; (iii) dynamic time inconsistency, credibility and monetary rules; (iv) central bank independence; (v) the role of microeconomic policies to increase aggregate supply; and (vi) the Lucas critique of econometric policy evaluation.

We begin with a discussion of the strong policy conclusion that fully anticipated changes in monetary policy will be ineffective in influencing the level of output and employment even in the short run, that is, the superneutrality of money.

5.5.1 The policy ineffectiveness proposition

The new classical policy ineffectiveness proposition was first presented in two influential papers by Sargent and Wallace (1975, 1976). The proposition can best be illustrated using the aggregate demand/supply model shown in Figure 5.3. Those readers unfamiliar with the derivation of this model should refer to any standard macroeconomics text, such as Mankiw (2003). In Figure 5.3, the economy is initially operating at point A, the triple intersection of AD0, SRAS0 and LRAS. At point A, in line with equation (5.3), the price level (P0) is fully anticipated (that is, the actual and expected price levels coincide) and output and employment are at their long-run (full information) equilibrium (natural) levels. Suppose the authorities announce that they intend to increase the money supply. Rational economic agents would take this information into account in forming their expectations and fully anticipate the effects of the increase in the money supply on the general price level, so that

Figure 5.3 The effects of anticipated and unanticipated changes in the money supply on the level of output and the price level

output and employment would remain unchanged at their natural levels. The rightward shift of the aggregate demand curve from AD0 to AD1 would be offset by an upward shift to the left of the positively sloped aggregate supply curve from SRAS0 to SRAS1, as money wages were increased following an immediate upward revision of price expectations. In this case the economy would move straight from point A to C, remaining on the vertical long-run aggregate supply curve with no change in output and employment even in the short run; that is, money is super-neutral.

In contrast, suppose the authorities surprise economic agents by increasing the money supply without announcing their intentions. In this situation firms and workers with incomplete information would misperceive the resultant increase in the general price level as an increase in relative prices and react by increasing the supply of output and labour. In other words, workers and firms would mistakenly perceive this as a real (as opposed to a nominal) increase in the demand for their services/goods and respond by increasing the supply of labour/output. In terms of Figure 5.3, the aggregate demand curve would shift to the right from AD0 to AD1 to intersect the positively sloped aggregate supply curve SRAS0 at point B. In line with equation (5.3), output (Y1) would deviate from its natural level (YN) as a consequence of deviations of the price level (P1) from its expected level (P0), that is, as the result of

expectational errors by agents. Any increase/decrease in output/unemployment would, it is argued, only be temporary. Once agents realized that there had been no change in relative prices, output and employment would return to their long-run equilibrium (natural) levels. In terms of Figure 5.3, as agents fully adjusted their price expectations the positively sloped aggregate supply curve would shift upwards to the left, from SRAS0 to SRAS1, to intersect AD1 at point C. It is interesting to note that the former new classical adjustment process discussed above (from A to C) corresponds to the orthodox monetarist case in the long run, while the latter adjustment process (from A to B to C) corresponds to the orthodox monetarist case in the short run, regardless of whether the increase in the money supply is anticipated or unanticipated. To summarize, the new classical analysis suggests that (i) an anticipated increase in the money supply will raise the price level and have no effect on real output and employment, and (ii) only unanticipated monetary surprises can affect real variables in the short run.

This strong policy ineffectiveness proposition has major implications for the controversy over the role and conduct of macroeconomic stabilization policy. If the money supply is determined by the authorities according to some ‘known’ rule, then the authorities will be unable to influence output and employment even in the short run by pursuing a systematic monetary policy as it can be anticipated by agents. For example, the authorities might adopt a monetary rule which allows for a given fixed rate of monetary growth of 6 per cent per annum. In forming their expectations of inflation, rational economic agents would include the anticipated effects of the 6 per cent expansion of the money supply. Consequently the systematic component (that is, 6 per cent) of the monetary rule would have no effect on real variables. If, in practice, the money supply grew at a rate of 8 per cent per annum, the non-systematic (unanticipated) component of monetary expansion (that is, 2 per cent per annum) would cause output and employment to rise temporarily above their long-run equilibrium (natural) levels, owing to errors in inflation expectations. Alternatively the authorities might allow the money supply to be determined by a feedback rule (for example, in response to changes in unemployment and output). Again changes in the rate of monetary growth which arise from a known feedback rule will be anticipated by agents, making the feedback policy rule ineffective. Only departures from a known monetary rule (such as policy errors made by the monetary authorities or unforeseen changes in policy) which are unanticipated will influence output.

The policy ineffectiveness proposition can be expressed algebraically in the following way (see Gordon, 1976). We begin by rewriting the Friedman– Phelps equation in modified linear form as:

where θ St represents an ‘exogenous’ supply shock (with zero mean) and Ut – UNt represents the deviation of unemployment from its natural rate. Equation (5.14) can be rewritten as:

Suppose a Keynesian-inspired monetary authority attempts to control monetary growth so that it grows at some constant rate (λ 0) plus some proportion (λ 1) of the previous period’s deviation of unemployment from its natural rate. In this case the actual rate of monetary growth will be:

where θ ˙ t signifies a random or unanticipated element in monetary growth.

M

Equation (5.18) indicates that the monetary authorities are operating a systematic feedback monetary rule which can be predicted by rational economic agents as it becomes part of their information set (Ω t–1) in equation (5.1). Rational economic agents will therefore have expectations of inflation based on the expected rate of monetary growth, shown in equation (5.19).

By subtracting (5.19) from (5.18) we obtain:

Subtracting (5.17) from (5.16) and substituting from (5.20) we derive equation (5.21):

Finally substituting (5.21) into (5.15) gives us:

The important point to notice about equation (5.22) is that the systematic component of monetary growth, (λ 0 + λ 1(Ut–1 – UNt–1)), which the government was attempting to use in order to prevent unemployment from deviating from its natural rate, does not enter into it. The only component of equation (5.22)

that the monetary authorities can influence directly is θ ˙ t the random com-

M ,

ponent of monetary growth. Therefore equation (5.22) tells us that, in a Sargent and Wallace world, unemployment can deviate from its natural rate as the result of unpredictable demand (θ Dt) and supply (θ St) shocks or unan-

ticipated monetary surprises θ ˙ t ). Any systematic feedback monetary rule,

M

(

by becoming part of economic agents’ information set, cannot cause inflation to deviate from its expected rate. Only departures from a known monetary rule (such as policy errors made by the monetary authorities or unforeseen changes in policy) which are unanticipated will influence output and employment.

In summary, the approach predicts that, as rational economic agents will take into account any known monetary rule in forming their expectations, the authorities will be unable to influence output and employment even in the short run by pursuing a systematic monetary policy. Furthermore, any attempt to affect output and employment by random or non-systematic monetary policy will, it is argued, only increase the variation of output and employment around their natural levels. It can be seen, therefore, that the argument advanced by new classicists against policy activism is subtly different from those put forward by orthodox monetarists (see Chapter 4, section 4.3.2 on the role and conduct of monetary policy).

The policy ineffectiveness proposition that only unanticipated monetary surprises have real output effects (or what is sometimes referred to as the ‘anticipated–unanticipated money debate’) has been the subject of a number of empirical studies. Early work, in particular the seminal papers by Barro (1977a, 1978), seemed to support the proposition. Using annual data for the US economy over the period 1941–76, Barro used a two-stage method in first estimating anticipated and unanticipated money growth before regressing output and unemployment on unanticipated money growth. In general, Barro’s studies provided support for the view that, while output and unemployment are significantly affected by unanticipated money growth, anticipated money growth has no real effects. However, subsequent studies, most notably by Mishkin (1982) and Gordon (1982a), found evidence to suggest that both unanticipated and anticipated monetary policy affect output and employment. Overall, while the empirical evidence is mixed, it does not appear to support

the view that systematic monetary policy has no real effects. Moreover, as Buiter (1980) pointed out, theoretical models can be constructed where even fully anticipated changes in the rate of monetary growth can have real affects by altering the rate inflation and hence the rate of return on money balances that have a zero nominal rate of return. This in turn will affect the rate of capital accumulation by changing the equilibrium portfolio composition. It also goes without saying that fully anticipated fiscal changes, such as changes in tax rates that alter labour supply and saving behaviour, will have real effects. ‘Clearly fiscal policy is non-neutral in even the most classical of systems’ (Buiter, 1980). In non-market-clearing models, where prices are fixed, anticipated changes in monetary policy will have real effects via the normal IS–LM–AD–AS mechanisms. In response to the Sargent and Wallace papers, Fischer (1977), Phelps and Taylor (1977) and Taylor (1980) produced models incorporating multi-period wage contracts and rational expectations where monetary policy is non-neutral (see Chapter 7).

In addition, many Keynesians find this whole approach misguided, preferring instead to explore the possibility that non market clearance can be compatible with maximising behaviour on the part of all market participants (Akerlof, 1979). In addition, the idea of stimulating aggregate demand when the economy is already in (full employment) equilibrium would have been anathema to Keynes. Why would such a policy ever be considered necessary? As Frank Hahn (1982, p. 75) has commented, ‘Keynesians were concerned with the problem of pushing the economy to its natural rate, not beyond it. If the economy is there already, we can all go home.’

5.5.2 The real costs of disinflation

The second main policy implication of the new classical approach concerns the output–employment costs of reducing inflation. New classical economists share the monetarist view that inflation is essentially a monetary phenomenon propagated by excessive monetary growth. However, substantial disagreement exists between economists over the real costs of disinflation. Here we will compare the new classical view with that of Keynesians and monetarists.

The amount of lost output that an economy endures in order to reduce inflation is known as the ‘sacrifice ratio’. In Keynesian models the sacrifice ratio tends to be large, even if agents have rational expectations, owing to the sluggish response of prices and wages to reductions in aggregate demand. Given gradual price adjustment, a deflationary impulse will inevitably lead to significant real losses which can be prolonged by hysteresis effects, that is, where a recession causes the natural rate of unemployment to increase (see Cross, 1988; Gordon, 1988; and Chapter 7). Some Keynesians have advocated the temporary use of incomes policy as a supplementary policy measure to accompany monetary restraint as a way of increasing the efficiency of

disinflation policies (see, for example, Lipsey, 1981). It should also be noted that Post Keynesian economists regard incomes policy as a crucial permanent anti-inflationary weapon. Monetary disinflation alone will tend to produce a permanently higher level of unemployment in Post Keynesian models (see Cornwall, 1984).

The orthodox monetarist view, discussed in Chapter 4, section 4.3.2, is that unemployment will rise following monetary contraction, the extent and duration of which depend on the degree of monetary contraction, the extent of institutional adaptations and how quickly people adjust downwards their expectations of future rates of inflation. The critical factor here is the responsiveness of expectations to the change of monetary regime and this in turn implies that the credibility and reputation of the monetary authority will play a crucial role in determining the sacrifice ratio.

In contrast to both the Keynesian and monetarist models, the new classical approach implies that announced/anticipated changes in monetary policy will have no effect on the level of output and employment even in the short run, provided the policy is credible. An announced monetary contraction which is believed will cause rational agents immediately to revise downwards their inflation expectations. The monetary authorities can in principle reduce the rate of inflation without the associated output and employment costs predicted by Keynesian and monetarist analysis; that is, the sacriflce ratio is zero! As one critic has noted, ‘in a Sargent–Wallace world the Fed could eliminate inflation simply by announcing that henceforth it would expand the money supply at a rate compatible with price stability’ (Gordon, 1978, p. 338). In terms of Figure 4.6, the rate of inflation could be reduced from A to D without any increase in unemployment. In such circumstances there is no necessity to follow a policy of gradual monetary contraction advocated by orthodox monetarists. Given the absence of output–employment costs, new classicists argue that the authorities might just as well announce a dramatic reduction in the rate of monetary expansion to reduce inflation to their preferred target rate.

With respect to the output–employment costs of reducing inflation, it is interesting to note briefly the prima facie evidence provided by the Reagan (USA) and Thatcher (UK) deflations in the early 1980s. Following the restrictive monetary policy pursued in both economies during this period, both the US economy (1981–2) and the UK economy (1980–81) experienced deep recessions. Between 1979 and 1983, inflation fell from 11.2 per cent to 3.2 per cent in the US economy and from 13.4 per cent to 4.6 per cent in the UK economy, while over the same period unemployment rose from 5.8 per cent to 9.6 per cent in the USA and from 4.7 to 11.1 per cent in the UK (see Tables 1.4 and 1.5). In commenting on the UK experience, Matthews and Minford (1987) attribute the severity of the recession in this period primarily to

adverse external and supply-side shocks. However, the monetary disinflation initiated by the Thatcher government was also a factor. This disinflation was unintentionally severe and as a result ‘expectations were quite unprepared for it’. Because initially the Thatcher government had a credibility problem, the ‘accidental shock treatment’ produced painful effects on output and employment. An important influence on credibility in new classical models is the growth path of government debt. New classical economists insist that in order to engineer a disinflation without experiencing a severe sacrifice ratio, a fiscal strategy is required which is compatible with the announced monetary policy, otherwise agents with rational expectations will expect a policy reversal (‘U- turn’) in the future. As Matthews and Minford (1987) point out, ‘A key feature of the Thatcher anti-inflation strategy was a parallel reduction in government budget deficits.’ This ‘Medium Term Financial Strategy’ was aimed at creating long-run credibility (see also Minford et al., 1980; Sargent and Wallace, 1981; Sargent, 1993, 1999) .

In the USA a ‘monetary policy experiment’ was conducted between October 1979 and the summer of 1982. This Volcker disinflation was also associated with a severe recession, although the influence of the second oil shock must also have been a contributory factor. In commenting on this case, Milton Friedman (1984) has argued that the relevant economic agents did not have any widespread belief in the new disinflationary policy announced by the Fed in October 1979. In a similar vein, Poole (1988) has observed that ‘a recession may be necessary to provide the evidence that the central bank is serious’. For a discussion of the US ‘monetarist experiment’, the reader is referred to Brimmer (1983) and B. Friedman (1988). Useful surveys relating to the issue of disinflation are provided by Dalziel (1991), Ball (1991, 1994) and Chadha et al. (1992).

From the above discussion it is clear that, for painless disinflation to occur, the public must believe that the monetary authority is prepared to carry through its announced monetary contraction. If policy announcements lack credibility, inflationary expectations will not fall sufficiently to prevent the economy from experiencing output–employment costs. Initially the arguments relating to the importance of credibility were forcefully presented by Fellner (1976, 1979). A second line of argument, closely related to the need for policy credibility, is that associated with the problem of dynamic time inconsistency. This matter was first raised in the seminal paper of Kydland and Prescott (1977) and we next examine the policy implications of this influential theory.

5.5.3 Dynamic time inconsistency, credibility and monetary rules

The ‘hard core’ monetarist case for a constant monetary growth rate rule was well articulated by Milton Friedman during the 1950s and 1960s. Friedman’s

case is based on a number of arguments, including the informational constraints facing policy makers; problems associated with time lags and forecasting; uncertainty with respect to the size of fiscal and monetary policy multipliers; the inflationary consequences of reducing unemployment below the natural rate; and a basic distrust of the political process compared to market forces. The Lucas–Sargent–Wallace policy ineffectiveness proposition calls into question the power of anticipated monetary policy to influence real variables, adding further weight to Friedman’s attack on discretionary policies. While the Walrasian theoretical framework of the new classical economists differed markedly from Friedman’s Marshallian approach, the policy conclusions of Lucas, Sargent and Wallace were ‘monetarist’ in that their models provided further ammunition against the Keynesian case for activist discretionary stabilization policies. For example, in his highly theoretical paper, ‘Expectations and the Neutrality of Money’, Lucas (1972a) demonstrates the optimality of Friedman’s k per cent rule.

In 1977, Kydland and Prescott provided a reformulation of the case against discretionary policies by developing an analytically rigorous new classical model where the policy maker is engaged in a strategic dynamic game with sophisticated forward-looking private sector agents. In this setting, discretionary monetary policy leads to an equilibrium outcome involving an ‘inflation bias’. As Ball (1995) notes, models based on dynamic consistency problems have now become the leading theories of moderate inflation.

The theory of economic policy which Kydland and Prescott attack in their paper is that which evolved during the 1950s and 1960s. The conventional approach, inspired by Tinbergen (1952), consists of three crucial steps. First, the policy maker must specify the targets or goals of economic policy (for example, low inflation and unemployment). Second, given this social welfare function which the policy maker is attempting to maximize, a set of instruments (monetary and fiscal) is chosen which will be used to achieve the targets. Finally, the policy maker must make use of an economic model so that the instruments may be set at their optimal values. This normative approach to economic policy is concerned with how policy makers should act and, within the context of optimal control theory, economists sought to identify the optimal policy in order to reach the best outcome, given the decision takers’ preferences (see Chow, 1975). Kydland and Prescott argue that there is ‘no way’ that ‘optimal control theory can be made applicable to economic planning when expectations are rational’. Although optimal control theory had proved to be very useful in the physical sciences, Kydland and Prescott deny that the control of social systems can be viewed in the same way. Within social systems there are intelligent agents who will attempt to anticipate policy actions. As a result, in dynamic economic systems where policy makers are involved with a sequence of actions over a period of time, ‘discretionary

policy, namely the selection of that decision which is best, given the current situation, does not result in the social objective function being maximised’ (Kydland and Prescott, 1977, p. 463). This apparent paradox results because ‘economic planning is not a game against nature but, rather, a game against rational economic agents’. This argument has very important implications both for the conduct of monetary policy and for the institutional structure most likely to generate credibility with respect to the stated objective of low inflation.

The fundamental insight provided by Kydland and Prescott relating to the evaluation of macroeconomic policy is that when economic agents are for- ward-looking the policy problem emerges as a dynamic game between intelligent players – the government (or monetary authorities) and the private sector (see Blackburn, 1987). Suppose a government formulates what it considers to be an optimal policy which is then announced to private agents. If this policy is believed, then in subsequent periods sticking to the announced policy may not remain optimal since, in the new situation, the government finds that it has an incentive to renege or cheat on its previously announced optimal policy. The difference between ex ante and ex post optimality is known as ‘time inconsistency’. As Blackburn (1992) notes, an optimal policy computed at time t is time-inconsistent if reoptimization at t + n implies a different optimal policy. Kydland and Prescott demonstrate how time-incon- sistent policies will significantly weaken the credibility of announced policies.

The demonstration that optimal plans are time-inconsistent is best illustrated in the macroeconomic context by examining a strategic game played between the monetary authorities and private economic agents, utilizing the Lucas monetary surprise version of the Phillips curve trade-off between inflation and unemployment to show how a consistent equilibrium will involve an inflationary bias. In the Kydland and Prescott model discretionary policies are incapable of achieving an optimal equilibrium. In what follows we assume that the monetary authorities can control the rate of inflation perfectly, that markets clear continuously and that economic agents have rational expectations. Equation (5.23) indicates that unemployment can be reduced by a positive inflation surprise:

Equation (5.23) represents the constraint facing the policy maker. Here, as

of inflation in time period t. Kydland and Prescott assume that expectations are rational as given by equation (5.24):