Policy Ineffectiveness Proposition
Encyclopedia
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 posited that monetary policy could not systematically manage the levels of output and employment in the economy.
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 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 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. More importantly, this behaviour 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 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.
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.
, 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 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. 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:
Thomas J. Sargent
Thomas John "Tom" Sargent is an American Nobel Memorial Prize in Economic Sciences winning economist, specializing in the fields of macroeconomics, monetary economics and time series econometrics...
and Neil Wallace
Neil Wallace
Neil Wallace is an American economist and professor at Pennsylvania State University. Wallace is considered one of the main proponents of new classical macroeconomics....
based upon the theory of rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
. It posited that monetary policy could not systematically manage the levels of output and employment in the economy.
Theory
Prior to the work of Sargent and Wallace, macroeconomic models were largely based on the adaptive expectationsAdaptive expectations
In economics, adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past...
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 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 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. More importantly, this behaviour seemed inconsistent with the stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...
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
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
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 remain constant and therefore so does output, no money illusion
Money illusion
In economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value of money is mistaken for its purchasing power...
occurs. Only stochastic shocks
Shock (economics)
In economics a shock is an unexpected or unpredictable event that affects an economy, either positively or negatively. Technically, it refers to an unpredictable change in exogenous factors—that is, factors unexplained by economics—which may have an impact on endogenous economic variables.The...
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
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
. 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 FriedmanMilton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
, 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
Stanley Fischer
Stanley "Stan" Fischer is an American-Israeli economist and the current Governor of the Bank of Israel. He previously served as Chief Economist at the World Bank.-Biography:...
(1977) and Edmund Phelps
Edmund Phelps
Edmund Strother Phelps, Jr. is an American economist and the winner of the 2006 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. Early in his career he became renowned for his research at Yale's Cowles Foundation in the first half of the 1960s on the sources of economic growth...
and John B. Taylor
John B. Taylor
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....
(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 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
Inflationary bias
Inflationary bias is the tendency of government control of the economy to lead to a higher than optimal level of inflation. The term may also refer to the practice of a public debt-ridden nation enacting policies which encourage inflation in the medium/long term.- Explanations :The Barro–Gordon...
. 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. TaylorJohn B. TaylorJohn 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....
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 neutralityNeutrality of moneyNeutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption....
propositions... The current edition contains many more examples of models in which a government faces a nontrivial policy choice than did the earlier edition.'