The Policy Implications of the New Classical Approach

The 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
The new classical school 243
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
244 Modern macroeconomics
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:
P˙ P˙ (U U ) S t t
e
t Nt t = − φ − + φθ (5.14)
The new classical school 245
where θSt 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:
U U P P S t N t t
e
t t = −1/φ( ˙ − ˙ ) + θ (5.15)
The structural relationship between inflation ˙Pt and the rate of monetary
growth ˙Mt is given by:
P˙ M˙ D t = t + θ t (5.16)
where θDt represents ‘unpredictable’ demand shocks (such as shocks from
the private sector) which also have a zero mean. If ˙Mt
e is the expected rate of
growth of the money supply, the rational expectation of inflation will be:
P˙ M˙ t
e
t
= e (5.17)
Suppose a Keynesian-inspired monetary authority attempts to control monetary
growth so that it grows at some constant rate (λ0) plus some proportion
(λ1) of the previous period’s deviation of unemployment from its natural rate.
In this case the actual rate of monetary growth will be:
M˙ (U U ) M˙ t t Nt t = + − − − + λ0 λ1 1 1 θ (5.18)
where θ ˙Mt signifies a random or unanticipated element in monetary growth.
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 (Ωt–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).
M˙ (U U ) t
e
t Nt = + − − − λ0 λ1 1 1 (5.19)
By subtracting (5.19) from (5.18) we obtain:
M˙ M˙ M˙ t t
e
− = θ t (5.20)
Subtracting (5.17) from (5.16) and substituting from (5.20) we derive equation
(5.21):
P˙ P˙ M˙ D t t
e
− = θ t + θ t (5.21)
246 Modern macroeconomics
Finally substituting (5.21) into (5.15) gives us:
Ut UNt Mt Dt St = −1/θ(θ ˙ + θ ) + θ (5.22)
The important point to notice about equation (5.22) is that the systematic
component of monetary growth, (λ0 + λ1(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 θM˙ t , the random component
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 (θDt) and supply (θSt) shocks or unanticipated
monetary surprises (θM˙ t ). Any systematic feedback monetary rule,
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 new classical school 247
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
248 Modern macroeconomics
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
The new classical school 249
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 (‘Uturn’)
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
250 Modern macroeconomics
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
The new classical school 251
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 forward-
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-inconsistent
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:
U U P P t N t
e
t t = + ψ( ˙ − ˙ ) (5.23)
Equation (5.23) represents the constraint facing the policy maker. Here, as
before, Ut is unemployment in time period t, UNt is the natural rate of unemployment,
ψ is a positive constant, ˙Pt
e is the expected and ˙Pt the actual rate
of inflation in time period t. Kydland and Prescott assume that expectations
are rational as given by equation (5.24):
252 Modern macroeconomics
P˙ E(P˙ | ) t
e
= t Ωt−1 (5.24)
where, as before, ˙Pt is the actual rate of inflation; E(Pt t ˙ |Ω −1) is the rational
expectation of the rate of inflation subject to the information available up to
the previous period (Ωt–1). Kydland and Prescott then specify that there is
some social objective function (S) which rationalizes the policy choice and is
of the form shown in equation (5.25):
S = S(P˙t ,Ut ), where S′(P˙t ) < 0, and S′(Ut ) < 0 (5.25)
The social objective function (5.25) indicates that inflation and unemployment
are ‘bads’ since a reduction in either or both increases social welfare. A
consistent policy will seek to maximize (5.25) subject to the Phillips curve
constraint given by equation (5.23). Figure 5.4 illustrates the Phillips curve
trade-off for two expected rates of inflation, ˙Pto
e and P˙ . tc
e The contours of the
social objective function are indicated by the indifference curves S1 S2 S3 and
S4. Given that inflation and unemployment are ‘bads’, S1 > S2 > S3 > S4, and
the form of the indifference curves implies that the ‘socially preferred’ rate of
inflation is zero. In Figure 5.4, all points on the vertical axis are potential
equilibrium positions, since at points O and C unemployment is at the natural
rate (that is, Ut = UNt) and agents are correctly forecasting inflation (that
is, ˙Pt
e = P˙ ). t The indifference curves indicate that the optimal position (consistent
equilibrium) is at point O where a combination of ˙Pt = zero and Ut =
UNt prevails. While the monetary authorities in this model can determine the
rate of inflation, the position of the Phillips curves in Figure 5.4 will depend
on the inflationary expectations of private economic agents. In this situation a
time-consistent equilibrium is achieved where the indifference curve S3 is at a
tangent to the Phillips curve passing through point C. Since C lies on S3, it is
clear that the time-consistent equilibrium is sub-optimal. Let us see how such
a situation can arise in the context of a dynamic game played out between
policy makers and private agents.
In a dynamic game, each player chooses a strategy which indicates how
they will behave as information is received during the game. The strategy
chosen by a particular player will depend on their perception of the strategies
likely to be followed by the other participants, as well as how they expect
other participants to be influenced by their own strategy. In a dynamic game,
each player will seek to maximize their own objective function, subject to
their perception of the strategies adopted by other players. The situation
where the game is between the government (monetary authorities) and private
agents is an example of a non-cooperative ‘Stackelberg’ game. Stackelberg
games have a hierarchical structure, with the dominant player acting as leader
and the remaining participants reacting to the strategy of the leader. In the
The new classical school 253
Figure 5.4 Consistent and optimal equilibrium
monetary policy game discussed by Kydland and Prescott, the government is
the dominant player. When the government decides on its optimal policy it
will take into account the likely reaction of the ‘followers’ (private agents). In
a Stackelberg game, unless there is a precommitment from the leader with
respect to the announced policy, the optimal policy will be dynamically
inconsistent because the government can improve its own pay-off by cheating.
Since the private sector players understand this, the time-consistent
equilibrium will be a ‘Nash’ equilibrium. In such a situation each player
correctly perceives that they are doing the best they can, given the actions of
the other players, with the leader relinquishing the dominant role (for a nontechnical
discussion of game theory, see Davis, 1983).
254 Modern macroeconomics
Suppose the economy is initially at the sub-optimal but time-consistent
equilibrium indicated by point C in Figure 5.4. In order to move the economy
to the optimal position indicated by point O, the monetary authorities announce
a target of zero inflation which will be achieved by reducing the
growth rate of the money supply from ˙Mc to M˙ o . If such an announcement
is credible and believed by private economic agents, then they will revise
downwards their inflationary expectations from ˙Ptc
e to P˙ , to
e causing the Phillips
curve to shift downwards from C to O. But once agents have revised their
expectations in response to the declared policy, what guarantee is there that
the monetary authorities will not renege on their promise and engineer an
inflationary surprise? As is clear from Figure 5.4, the optimal policy for the
authorities to follow is time-inconsistent. If they exercise their discretionary
powers and increase the rate of monetary growth in order to create an ‘inflation
surprise’, the economy can reach point A on S1, which is clearly superior
to point O. However, such a position is unsustainable, since at point A
unemployment is below the natural rate and ˙Pt > P˙t .
e Rational agents will
soon realize they have been fooled and the economy will return to the timeconsistent
equilibrium at point C. Note that there is no incentive for the
authorities to try to expand the economy in order to reduce unemployment
once position C is attained since such a policy will reduce welfare; that is, the
economy would in this case move to an inferior social indifference curve.
To sum up, while position A > O > C in Figure 5.4, only C is timeconsistent.
Position A is unsustainable since unemployment is below the
natural rate, and at position O the authorities have an incentive to cheat in
order to achieve a higher level of (temporary) social welfare. What this
example illustrates is that, if the monetary authorities have discretionary
powers, they will have an incentive to cheat. Hence announced policies
which are time-inconsistent will not be credible. Because the other players in
the inflation game know the authorities’ objective function, they will not
adjust their inflationary expectations in response to announcements which
lack credibility and in the absence of binding rules the economy will not be
able to reach the optimal but time-inconsistent position indicated by point O.
The non-cooperative Nash equilibrium indicated by point C demonstrates
that discretionary policy produces a sub-optimal outcome exhibiting an inflationary
bias. Because rational agents can anticipate the strategy of monetary
authorities which possess discretionary powers, they will anticipate inflation
of P˙tc .
e Hence policy makers must also supply inflation equal to that expected
by the private sector in order to prevent a squeeze on output. An optimal
policy which lacks credibility because of time inconsistency will therefore be
neither optimal nor feasible. Discretionary policies which emphasize selecting
the best policy given the existing situation will lead to a consistent, but
sub-optimal, outcome. The only way to achieve the optimal position, O, is for
The new classical school 255
Figure 5.5 Game played between the monetary authorities and wage
negotiators
the monetary authorities to pre-commit to a non-contingent monetary rule
consistent with price stability.
The various outcomes which can arise in the game played between the
monetary authorities and wage negotiators has been neatly captured by Taylor
(1985). Figure 5.5, which is adapted from Taylor (1985), shows the four
possible outcomes in a non-cooperative game between private agents and the
central bank. The time-consistent outcome is shown by C, whereas the optimal
outcome of low inflation with unemployment at the natural rate is shown
by O. The temptation for a government to stimulate the economy because of
time inconsistency is indicated by outcome A, whereas the decision not to
validate a high rate of expected inflation and high wage increases will produce
a recession and is indicated by outcome B.
The credibility problem identified by Kydland and Prescott arises most
clearly in the situation of a one-shot full information non-cooperative
256 Modern macroeconomics
Stackelberg game where the government has discretion with respect to monetary
policy. However, in the situation of economic policy making, this is
unrealistic since the game will be repeated. In the case of a repeated game (a
super-game) the policy maker is forced to take a longer-term view since the
future consequences of current policy decisions will influence the reputation
of the policy maker. In this situation the government’s incentive to cheat is
reduced because they face an intertemporal trade-off between the current
gains from reneging and the future costs which inevitably arise from riding
the Phillips curve.
This issue of reputation is taken up in their development and popularization
of the time-inconsistency model by Barro and Gordon (1983a, 1983b).
They explore the possibilities of substituting the policy maker’s reputation
for more formal rules. The work of Barro and Gordon represents a significant
contribution to the positive analysis of monetary policy which is concerned
with the way policy makers do behave, rather than how they should behave. If
economists can agree that inflation is primarily determined by monetary
growth, why do governments allow excessive monetary growth? In the Barro–
Gordon model an inflationary bias results because the monetary authorities
are not bound by rules. However, even a government exercising discretion
will be influenced by reputational considerations if it faces punishment from
private agents, and it must consequently weigh up the gains from cheating on
its announced policy against the future costs of the higher inflation which
characterizes the discretionary equilibrium. In this scenario, ‘a different form
of equilibrium may emerge in which the policymaker forgoes short-term
gains for the sake of maintaining a long-term reputation’ (Barro and Gordon,
1983b). Given this intertemporal trade-off between current gains (in terms of
lower unemployment and higher output) and the future costs, the equilibrium
of this game will depend on the discount rate of the policy maker. The higher
the discount rate, the closer the equilibrium solution is to the time-consistent
equilibrium of the Kydland–Prescott model (point C in Figure 5.4). If the
discount rate is low, the equilibrium position will be closer to the optimal
zero inflation pre-commitment outcome. Note that it is the presence of precommitment
that distinguishes a monetary regime based on rules compared
to one based on discretion.
One problem with the above analysis is that private agents do not know
what type of government behaviour they face since they have incomplete
information (see Driffill, 1988). Given uncertainty with respect to government
intentions, private agents will carefully analyse various signals in the
form of policy actions and announcements. In this scenario it is difficult for
private agents to distinguish ‘hard-nosed’ (zero-inflation) administrations from
‘wet’ (high-inflation) administrations, since ‘wets’ have an incentive to masquerade
as ‘hard-nosed’. But as Blackburn (1992) has observed, agents ‘extract
The new classical school 257
information about the government’s identity by watching what it does, knowing
full well that what they do observe may be nothing more than the
dissembling actions of an impostor’. Backus and Driffill (1985) have extended
the Barro and Gordon framework to take into account uncertainty on
the part of the private sector with respect to the true intentions of the policy
maker. Given this uncertainty, a dry, hard-nosed government will inevitably
face a high sacrifice ratio if it initiates disinflationary policies and engages in
a game of ‘chicken’ with wage negotiators. For detailed surveys of the issues
discussed in this section, the reader should consult Barro (1986), Persson
(1988), Blackburn and Christensen (1989) and Fischer (1990).
More recently Svensson (1997a) has shown how inflation targeting has
emerged as a strategy designed to eliminate the inflation bias inherent in
discretionary monetary policies. The time-inconsistency literature pioneered
by Kydland and Prescott and Barro and Gordon assumes that monetary
authorities with discretion will attempt to achieve an implicit employment
target by reducing unemployment below the natural rate, which they deem to
be inefficiently high. This problem has led economists to search for credible
monetary frameworks to help solve the inflation bias problem. However, the
‘first-best’ solution is to correct the supply-side distortions that are causing
the natural rate of unemployment to be higher than the monetary authorities
desire, that is, tackle the problem at source. If this solution is for some reason
politically infeasible (strong trade unions), a second-best solution involves a
commitment to a monetary policy rule or assigning the monetary authorities
an employment target equal to the natural rate. If none of these solutions is
feasible, then policy will be discretionary and the economy will display an
inflation bias relative to the second-best equilibrium. Svensson classes the
discretionary (time-inconsistent) outcome as a fourth-best solution. Improvements
on the fourth-best outcome can be achieved by ‘modifying central
bank preferences’ via delegation of monetary policy to a ‘conservative central
banker’ (Rogoff, 1985) or by adopting optimal central bank contracts (Walsh,
1993, 1995a). Svensson argues that inflation targeting can move an economy
close to a second-best solution.
5.5.4 Central bank independence
The debate relating to central bank independence (CBI) has been very much
influenced by new classical thinking, especially with respect to inflationary
expectations, time inconsistency, reputation and credibility. If we accept the
Kydland–Prescott argument that discretionary policies lead to an inflation
bias, then it is clearly necessary to establish some institutional foundation
that will constrain discretionary actions. Many economists are persuaded that
some form of CBI will provide the necessary restraint. The theoretical case
for CBI relates to the general acceptance of the natural rate hypothesis that in
258 Modern macroeconomics
the long run the rate of inflation is independent of the level of unemployment
and that discretionary policies are likely to lead to an inflation bias. Hence
with no long-run exploitable trade-off, far-sighted monetary authorities ought
to select a position on the long-run Phillips curve consistent with a low
sustainable rate of inflation (a point near to O in Figure 5.4). The dynamic
inconsistency theories of inflation initiated by Kydland and Prescott and
developed by Barro and Gordon, and Backus and Driffill, provide an explanation
of why excessive (moderate) inflation will be the likely outcome of a
monetary regime where long-term commitments are precluded. Such discretionary
regimes contrast sharply with monetary regimes such as the Gold
Standard, where the underlying rules of the game revolve around a precommitment
to price stability. The emphasis of these models on the importance
of institutions and rules for maintaining price stability provides a strong case
for the establishment of independent central banks whose discretion is constrained
by explicit anti-inflation objectives acting as a pre-commitment device.
Since the problem of credibility has its source in the discretionary powers of
the monetary authorities with respect to the conduct of monetary policy, this
could be overcome by transferring the responsibility for anti-inflationary
policy to a non-political independent central bank. In addition, an independent
central bank will benefit from a ‘credibility bonus’, whereby disinflationary
policies can be accomplished at a low ‘sacrifice ratio’ (Cukierman, 1992;
Goodhart, 1994a, 1994b).
In the debate over CBI it is important to make a distinction between ‘goal
independence’ and ‘instrument independence’ (see Fischer, 1995a, 1995b).
The former implies that the central bank sets its own objectives (that is,
political independence), while the latter refers to independence with respect
to the various levers of monetary policy (that is, economic independence).
The recently (May 1997) created ‘independent’ Bank of England has instrument
independence only. Initially, an inflation target of 2.5 per cent was set
by government, which formed the Bank’s explicitly stated monetary policy
objective. Therefore, in the UK, the decisions relating to goals remain in the
political sphere (Bean, 1998; Budd, 1998).
As noted above, Svensson (1997a) argues that the inflation bias associated
with the time-inconsistency problem can be improved upon by
‘modifying central bank preferences’ via delegation of monetary policy to a
‘conservative central banker’ (for example Alan Greenspan) as suggested
by Rogoff (1985) or by adopting optimal central bank contracts, as suggested
by Walsh (1993, 1995a). Rogoff’s conservative central banker has
both goal and instrument independence and is best represented by the
German Bundesbank, which before European Monetary Union remained
the most independent central bank in Europe (Tavelli et al., 1998). In
Rogoff’s model an inflation-averse conservative central banker is appointed
The new classical school 259
who places a higher relative weight on the control of inflation than does
society in general (for example President Jimmy Carter’s appointment of
Paul Volcker as Chairman of the Fed in 1979). This is meant to ensure that
the excessive inflation associated with the time-inconsistency problem is
kept low in circumstances where it would otherwise be difficult to establish
a pre-commitment to low inflation. Overall, lower average inflation and
higher output variability are predicted from this model (Waller and Walsh,
1996). However, the research of Alesina and Summers (1993) shows that
only the first of these two predictions appears in cross-sectional data. In
contrast, Hutchison and Walsh (1998), in a recent study of the experience of
New Zealand, find that central bank reform appears to have increased the
short-run output–inflation trade-off. In Rogoff’s model the conservative
central banker reacts less to supply shocks than someone who shared society’s
preferences, indicating a potential trade-off between flexibility and
commitment. In response to this problem Lohmann (1992) suggests that the
design of the central bank institution should involve the granting of partial
independence to a conservative central banker who places more weight on
inflation than the policy maker, but ‘the policymaker retains the option to
over-ride the central bank’s decisions at some strictly positive but finite
cost’. Such a clause has been built into the Bank of England Act (1998),
where the following reserve power is set out: ‘The Treasury, after consultation
with the Governor of the Bank, may by order give the Bank directions
with respect to monetary policy if they are satisfied that the directions are
required in the public interest and by extreme economic circumstances.’ It
remains to be seen if such powers are ever used.
The contracting model, associated with Walsh (1993, 1995a, 1998), utilizes
a principal–agent framework and emphasizes the accountability of the
central bank. In Walsh’s contracting approach the central bank has instrument
independence but no goal independence. The central bank’s rewards and
penalties are based on its achievements with respect to inflation control. The
Reserve Bank of New Zealand resembles this principal–agent type model. An
important issue in the contracting approach is the optimal length of contract
for a central banker (Muscatelli, 1998). Long terms of appointment will
reduce the role of electoral surprises as explained in Alesina’s partisan model
(see Chapter 10). But terms of office that are too long may be costly if
societal preferences are subject to frequent shifts. Waller and Walsh (1996)
argue that the optimal term length ‘must balance the advantages in reducing
election effects with the need to ensure that the preferences reflected in
monetary policy are those of the voting public’.
The empirical case for CBI is linked to cross-country evidence which shows
that for advanced industrial countries there is a negative relationship between
CBI and inflation. During the last 15 years a considerable amount of research
260 Modern macroeconomics
has been carried out which has examined the relationship between central bank
independence and economic performance (see Grilli et al., 1991; Bernanke and
Mishkin, 1992; Alesina and Summers, 1993; Eijffinger and Schaling, 1993;
Bleaney, 1996; Eijffinger, 2002a, 2002b). The central difficulty recognized by
researchers into the economic impact of central bank independence is the
problem of constructing an index of independence. Alesina and Summers
(1993) identify the ability of the central bank to select its policy objectives
without the influence of government, the selection procedure of the governor of
the central bank, the ability to use monetary instruments without restrictions
and the requirement of the central bank to finance fiscal deficits as key indicators
that can be used to construct a measure of central bank independence.
Using a composite index derived from Parkin and Bade (1982a) and Grilli et al.
(1991), Alesina and Summers examined the correlation between an index of
independence and some major economic indicators. Table 5.2 indicates that,
‘while central bank independence promotes price stability, it has no measurable
impact on real economic performance’ (Alesina and Summers, 1993, p. 151).
Table 5.2 Central bank independence and economic performance
Country Average index Average Average Average
of central bank inflation unemployment real GNP
independence 1955–88 rate growth
1958–88 1955–87
Spain 1.5 8.5 n/a 4.2
New Zealand 1 7.6 n/a 3.0
Australia 2.0 6.4 4.7 4.0
Italy 1.75 7.3 7.0 4.0
United Kingdom 2 6.7 5.3 2.4
France 2 6.1 4.2 3.9
Denmark 2.5 6.5 6.1 3.3
Belgium 2 4.1 8.0 3.1
Norway 2 6.1 2.1 4.0
Sweden 2 6.1 2.1 2.9
Canada 2.5 4.5 7.0 4.1
Netherlands 2.5 4.2 5.1 3.4
Japan 2.5 4.9 1.8 6.7
United States 3.5 4.1 6.0 3.0
Germany 4 3.0 3.6 3.4
Switzerland 4 3.2 n/a 2.7
Source: Alesina and Summers (1993).
The new classical school 261
Source: Alesina and Summers (1993).
Figure 5.6 The relationship between average inflation and central bank
independence
The ‘near perfect’ negative correlation between inflation and central bank
independence is clearly visible in Figure 5.6. However, as Alesina and Summers
recognize, correlation does not prove causation, and the excellent
anti-inflationary performance of Germany may have more to do with the public
aversion to inflation following the disastrous experience of the hyperinflation in
1923 than the existence of an independent central bank. In this case the independent
central bank could be an effect of the German public aversion to
inflation rather than a cause of low inflation. Indeed, the reputation established
by the German Bundesbank for maintaining low inflation was one important
reason given by the UK government for joining the ERM in October 1990. The
participation of the UK in such a regime, where monetary policy is determined
by an anti-inflationary central bank which has an established reputation and
credibility, was intended to tie the hands of domestic policy makers and help
lower inflationary expectations (see Alogoskoufis et al., 1992).
Considerable research has also been conducted into the role played by
politics in influencing economic performance. The ‘political business cycle’
or ‘monetary politics’ literature also suggests that CBI would help reduce the
problem of political distortions in macroeconomic policy making. What is
now known as the ‘new political macroeconomics’ has been heavily influ262
Modern macroeconomics
enced by the research of Alberto Alesina. His work has shown that the
imposition of rational expectations does not remove the importance of political
factors in business cycle analysis and in general the political business
cycle literature provides more ammunition to those economists who favour
taking monetary policy out of the hands of elected politicians. Excellent
surveys of the monetary politics literature can be found in Alesina and Roubini
with Cohen (1997) and Drazen (2000a); see Chapter 10.
While CBI might avoid the dynamic time-inconsistency problems identified
by Kydland and Prescott and produce lower average rates of inflation,
many economists doubt that, overall, a rules-bound central bank will perform
better than a central bank that is allowed to exercise discretion given the
possibility of large unforeseen shocks. A central bank which could exercise
discretion in the face of large shocks may be a more attractive alternative to
rule-based policies. This is certainly the view of Keynesians such as Stiglitz,
Solow and Tobin (see Solow and Taylor, 1998; Tobin, 1998; Stiglitz, 1999a).
Other economists who have worked on the inside of major central banks,
such as Blinder (1997b, 1998) at the US Fed, and Goodhart (1994a) at the
Bank of England, are not convinced of the usefulness or realism of the gametheoretic
approach to central bank behaviour. The research of Bernanke and
Mishkin also confirms that ‘Central banks never and nowhere adhere to strict,
ironclad rules for monetary growth’ (Bernanke and Mishkin, 1992, p. 186).
One of the most important theoretical objections to CBI is the potential for
conflict that it generates between the monetary and fiscal authorities (Doyle
and Weale, 1994; Nordhaus, 1994). It is recognized that the separation of
fiscal and monetary management can lead to coordination problems which
can undermine credibility. In countries where this has led to conflict (such as
the USA in the period 1979–82) large fiscal deficits and high real interest
rates have resulted. This monetary/fiscal mix is not conducive to growth and,
during the early period of Reaganomics in the USA, came in for severe
criticism from many economists (Blanchard, 1986; Modigliani, 1988b; and
Tobin, 1987). The tight-monetary easy-fiscal mix is hardly a surprising combination
given the predominant motivations that drive the Fed and the US
Treasury. Whereas independent central banks tend to emphasize monetary
austerity and low inflation, the fiscal authorities (politicians) know that increased
government expenditure and reduced taxes are the ‘meat, potatoes
and gravy of politics’ (Nordhaus, 1994). To the critics CBI is no panacea. In
particular, to say that inflation should be the primary goal of the central bank
is very different from making inflation the sole goal of monetary policy in all
circumstances (Akhtar, 1995; Carvalho, 1995/6; Minford, 1997; Forder, 1998;
Posen, 1998). As Blackburn (1992) concludes, ‘the credibility of monetary
policy does not depend upon monetary policy alone but also upon the macroeconomic
programme in its entirety’.
The new classical school 263
5.5.5 Microeconomic policies to increase aggregate supply
The next policy implication of the new classical approach we consider concerns
what policies the authorities should pursue if they wish to increase
output/reduce unemployment permanently (the role of monetary policy is not
to try to reduce unemployment permanently but to keep inflation low and
stable). As we have already seen, microeconomic policies to reduce distortions
in the labour market have been recommended as the ‘first-best’ solution
to the inflation bias problem identified by Kydland and Prescott (1977).
Unemployment is regarded as an equilibrium outcome reflecting the optimal
decisions of workers who substitute work/leisure in response to movements
in current and expected future real wages. The labour market continuously
clears, so that anyone wanting to work at the current real wage can do so.
Those who are unemployed voluntarily choose not to work at the current real
wage (Lucas, 1978a). Changes in output and employment are held to reflect
the equilibrium supply decisions of firms and workers, given their perceptions
of relative prices. It follows from this view that the appropriate policy
measures to increase output/reduce unemployment are those that increase the
microeconomic incentives for firms and workers to supply more output and
labour (examples of the wide range of often highly controversial supply-side
policies which have been pursued over recent years can be found in Chapter
4, section 4.3.2; see also Minford et al., 1985; Minford, 1991). The importance
of supply-side reforms has recently been taken up by Lucas. In his
Presidential Address to the American Economic Association in January 2003,
Lucas focused on ‘Macroeconomic Priorities’ (Lucas, 2003). In an analysis
using US performance over the last 50 years as a benchmark, Lucas concluded
that the potential for welfare gains from better long-run, supply-side
policies far exceeds the potential gains to be had from further improvements
in short-run stabilization policies.
To some economists the unemployment problem in Europe is not fundamentally
a monetary policy issue but a suppy-side problem, often referred to as
‘Eurosclerosis’. During the 1950s and 1960s the European ‘welfare state’ OECD
economies experienced lower unemployment on average than that experienced
in the USA. Since around 1980 this experience has been reversed. Many
economists have attributed the poor labour market performance in Europe to
various institutional changes which have adversely affected the flexibility of
the labour market, in particular measures relating to the amount and duration of
unemployment benefit, housing policies which limit mobility, minimum wage
legislation, job protection legislation which increases hiring and firing costs,
the ‘tax wedge’ between the cost of labour to firms (production wage) and the
net income to workers (consumption wage), and ‘insider’ power (Siebert, 1997;
Nickell, 1997). In the face of an increasingly turbulent economic environment,
economies require ongoing restructuring. Ljungqvist and Sargent (1998) argue
264 Modern macroeconomics
that the generous entitlement programmes in the European OECD welfare
states have generated ‘a virtual time bomb waiting to explode’ . That explosion
arrives when large economic shocks occur more frequently. The welfare state
programmes hinder the necessary restructuring of the economy and this shows
up as high and prolonged rates of unemployment.
While accepting the validity of some of the supply-side arguments, Solow
(1998) and Modigliani (1996) see a significant part of the rise in European
unemployment as having its origin in the tight anti-inflationary monetary
policies which have been a characteristic of the past two decades. The solution
to the unemployment problem in Europe therefore requires micro-oriented
supply-side policies combined with more expansionary aggregate demand
policies.
5.5.6 The Lucas critique of econometric policy evaluation
The final implication of the new classical approach for the formulation of
macroeconomic policy concerns what is popularly known as the ‘Lucas critique’,
after the title of Lucas’s seminal paper in which the proposition first
appeared. Lucas (1976) attacked the established practice of using large-scale
macroeconometric models to evaluate the consequences of alternative policy
scenarios, given that such policy simulations are based on the assumption
that the parameters of the model remain unchanged when there is a change in
policy. The Keynesian macroeconometric models developed during the 1950s
and 1960s consisted of ‘systems of equations’ involving endogenous variables
and exogenous variables. Such models, following Koopmans (1949),
contain four types of equation referred to as ‘structural equations’, namely:
1. identities, equations that are true by definition;
2. equations that embody institutional rules, such as tax schedules;
3. equations that specify the technological constraints, such as production
functions;
4. behavioural equations that describe the way in which individuals or
groups will respond to the economic environment; for example, wage
adjustment, consumption, investment and money demand functions.
A good example of this type of ‘system of equation’ model is the famous
FMP model (named after the Federal Reserve–MIT–University of Pennsylvania
model) constructed in the USA by Ando and Modigliani. Such models
were used for forecasting purposes and to test the likely impact of stochastic
or random shocks. The model builders used historical data to estimate the
model, and then utilized the model to analyse the likely consequences of
alternative policies. The typical Keynesian model of the 1960s/early 1970s
was based on the IS–LM–AD–AS framework combined with a Phillips curve
The new classical school 265
relationship. Obviously the behaviour of this type of model will, among other
things, depend on the estimated value of the coefficients of the variables in
the model. For example, such models typically include a consumption function
as one of the key relationships. Suppose the consumption function takes
the following simple form: C = α + β(Y – T). That is, consumption is
proportional to disposable (after tax) income (Y – T). However, in this simple
Keynesian consumption function the parameters (α, β) will depend on the
optimal decisions that economic agents made in the past relating to how
much to consume and save given their utility function; that is, these parameters
were formed during an earlier optimization process directly influenced
by the particular policy regime prevailing at the time. Lucas argues that we
cannot use equations such as this to construct models for predictive purposes
because their parameters will typically alter as the optimal (consumption)
responses of rational utility-maximizing economic agents to the policy changes
work their way through the model. The parameters of large-scale macroeconometric
models may not remain constant (invariant) in the face of policy
changes, since economic agents may adjust their expectations and behaviour
to the new environment (Sargent, 1999, refers to this as the problem of
‘drifting coefficients’). Expectations play a crucial role in the economy because
of the way in which they influence the behaviour of consumers, firms,
investors, workers and all other economic agents. Moreover, the expectations
of economic agents depend on many things, including the economic policies
being pursued by the government. If expectations are assumed to be rational,
economic agents adjust their expectations when governments change their
economic policies. Macroeconometric models should thus take into account
the fact that any change in policy will systematically alter the structure of the
macroeconometric model. Private sector structural behavioural relationships
are non-invariant when the government policy changes. Thus, estimating the
effect of a policy change requires knowing how economic agents’ expectations
will change in response to the policy change. Lucas (1976) argued that
the traditional (Keynesian-dominated) methods of policy evaluation do not
adequately take into account the impact of policy on expectations. Therefore,
Lucas questioned the use of such models, arguing that:
given that the structure of an econometric model consists of optimal decision rules
of economic agents, and that optimal decision rules vary systematically with
changes in the structure of series relevant to the decision maker, it follows that any
change in policy will systematically alter the structure of econometric models.
In other words, the parameters of large-scale macroeconometric models are
unlikely to remain constant in the face of policy changes, since rational economic
agents may adjust their behaviour to the new environment. Because
the estimated equations in most existing Keynesian-style macroeconometric
266 Modern macroeconomics
models do not change with alternative policies, any advice given from policy
simulations is likely to be misleading. When trying to predict the impact on the
economy of a change in policy it is a mistake, according to Lucas, to take as
given the relations estimated from past data.
This weakness of Keynesian-style macroeconometric models was particularly
exposed during the 1970s as inflation accelerated and unemployment
increased. The experiences of the 1950s and 1960s had led some policy makers
and economic theorists to believe that there was a stable long-run trade-off
between inflation and unemployment. However, once policy makers, influenced
by this idea, shifted the policy regime and allowed unemployment to fall
and inflation to rise, the Phillips curve shifted as the expectations of economic
agents responded to the experience of higher inflation. Thus the predictions of
orthodox Keynesian models turned out to be ‘wildly incorrect’ and a ‘spectacular
failure’, being based on a doctrine that was ‘fundamentally flawed’ (Lucas
and Sargent, 1978). Lucas’s rational expectations version of the Friedman–
Phelps natural rate theory implies that policy makers cannot base policy on the
apparent existence of any short-run Phillips curve trade-off. The monetary
authorities should aim to achieve low inflation, which has significant welfare
gains (see Sargent, 1999; Lucas, 2000a, 2003).
The Lucas critique has profound implications for the formulation of macroeconomic
policy. Since policy makers cannot predict the effects of new and
different economic policies on the parameters of their models, simulations
using existing models cannot in turn be used to predict the consequences of
alternative policy regimes. In Lucas’s view the invariability of parameters in
a model to policy changes cannot be guaranteed in Keynesian-type disequilibrium
models. In contrast, the advantage of equilibrium theorizing is that,
by focusing attention on individuals’ objectives and constraints, it is much
more likely that the resulting model will consist entirely of structural relations
which are invariant to changes in policy. Lucas identified the treatment
of expectations as a major defect of the standard large-scale macroeconometric
models. With rational expectations, agents will react quickly to announced
policy changes. The underprediction of inflation during the late 1960s and
early 1970s seemed to confirm Lucas’s argument. In 1978 Lucas and Sargent
famously declared that ‘existing Keynesian macroeconometric models are
incapable of providing reliable guidance in formulating monetary, fiscal and
other types of policy’.
The Lucas critique implies that the building of macroeconometric models
needs to be wholly reconsidered so that the equations are structural or behavioural
in nature. Lucas and Sargent (1978) claim that equilibrium models are
free of the difficulties associated with the existing Keynesian macroeconometric
models and can account for the main quantitative features of business cycles.
Ultimately the influence of the Lucas critique contributed to the methodoThe
new classical school 267
logical approach adopted in the 1980s by modern new classical theorists of
the business cycle, namely ‘Real Business Cycle’ theory (see Figure 5.7).
Such models attempt to derive behavioural relationships within a dynamic
optimization setting.
With respect to macroeconomic stabilization policy, the Lucas critique also
‘directs attention to the necessity of thinking of policy as a choice of stable
“rules of the game”, well understood by economic agents. Only in such a
setting will economic theory help us to predict the actions agents will choose
to take’ (Lucas and Sargent, 1978).
However, some economists, such as Alan Blinder, believe that the ‘Lucas
critique’ had a negative impact on progress in macroeconomics (see Snowdon,
2001a). In addition, direct tests of the Lucas critique have not provided
strong support for the proposition that policy changes lead to shifts of the
coefficients on behavioural equations (see Hoover, 1995a). Blanchard (1984)
has shown that ‘there is no evidence of a major shift of the Phillips curve’
during the change of policy regime adopted during the Volcker disinflation.
Other economists have pointed out that the Volcker disinflation involved a
lower sacrifice ratio than would have been expected before October 1979,
when the policy was implemented (see Sargent, 1999). Finally, it should be
noted that even the structural parameters of new classical ‘equilibrium’ models
may not be invariant to policy changes if economic agents’ tastes and
technology change following a shift in the rules of economic policy. In
practice it would seem that the significance of the Lucas critique depends
upon the stability of the parameters of a model following the particular policy
change under consideration