What sense would it make for workers to maintain wages that
are too high to give them employment---that price them out of the
market? The answer has to be that it would make no sense when
workers know what wage rate would give them employment. Correspondingly,
it makes no sense for firms to agree to wage levels so high that it
becomes infeasible to employ the quantity of labour that will maximize
long-run profits. The problem is that in an economy where the factors that
determine aggregate demand (world interest rates, preferences for
domestic consumption, investment, and net exports, and the demand
for money) are variable and not completely predictable, workers
and firms don't know what wage rate and corresponding price
level will generate full employment. If they knew, it would be
in their interest to set wages and prices at that level.
The full-employment flexible wage and price case is useful
in two situations: first, when we want to model the effects on
the economy of shocks to goods or asset markets that are widely
known, in which case wages and prices will adjust immediately to
them; and second, when we want to model the long-run effects of
shocks when everyone has had time to adjust to them. The fixed
wage and price scenario is useful for the short run during which
wage and price setters are unaware of shifts that have occurred
in the factors driving aggregate demand.
In practical cases, of course, some knowledge of the future
course of events will exist but this knowledge will be incomplete.
The amount of price and wage adjustment that actually occurs will
thus vary from situation to situation and the effects on the endogenous
variables of exogenous shocks over any period will lie somewhere between
the two extreme cases of no adjustment and complete adjustment.
Such in-between cases are difficult to model because reliable theories of
how and when economic decision makers learn about unfolding
events are non-existent.
Nevertheless, our analysis is based on the premise that
people always use all the information available to them in making
economic decisions. Information may be poor and incomplete
and subject to alternative interpretations. But we assume that
people to the best they can---they don't throw useful information away.
This idea that people use all available information as best they can is
called rational expectations.
Rational expectations does not imply that economic decision
makers always make the correct predictions about the future. In
general, they make wrong predictions. What it implies is that
their predictions are unbiased---that is, they are just as likely
to be wrong in one direction as in the other. If a person knows
that they tend to overestimate things, they will tone down future
predictions to compensate---if they know that they typically
underestimate future magnitudes they will add in a fudge factor.
There is thus no basis for assuming that any particular forecast
will be too high rather than too low, although, with hindsight, it will
rarely be accurate.
The basic idea behind countercyclical monetary and fiscal policy is that
the authorities, when the country is small, can adjust the money supply under
flexible exchange rates and fiscal policy under fixed exchange
rates to continuously maintain aggregate demand at a level that
will maintain full employment, given the errors that the private
sector will make in setting wages and prices. And when the economy is
big, the authorities can operate monetary and fiscal policy in this way
under flexible exchange rates and also under fixed exchange rates when
other countries are fixing their exchange rates to its currency.
Over the business-cycle the government, based on the advice of its economists,
will tighten the money supply in times of boom and ease it in times of
recession (and correspondingly with fiscal policy) in order to
smooth out the fluctuations in employment. This easing and
tightening occurs, of course, around a trend of money growth that
will generate an acceptable time-path of the price level over the
long run.
In implementing counter-cyclical policy, the authorities
face a difficult problem. The effects on the economy of changes
in the money supply will take place over a period of several
months---monetary expansion or contraction has to lead to a portfolio
adjustment which will cause the exchange rate to change, and that exchange
rate change, in turn, has to cause the trade balance to change
before aggregate demand will be affected. If the country is big, the
world interest rate will also fall, leading to an increase in aggregate
demand. In order to influence
output and employment, say, six months from now, the central
bank has to solve two problems: First, it has to predict where
these variables will be six months hence if no counter-cyclical
monetary policy is applied. Then, it has to determine the exact
dosage of monetary expansion that will produce the desired effect
on employment six months down the road. Essentially the same
problem arises with fiscal policy with the further complication
that it has to be carefully designed to produce the correct results
and legislation often has to be passed in order to implement it.
Given the notoriously poor ability of economists (and
everyone else) to predict the future, the problem of what dosage
of monetary expansion or contraction to apply and when to apply
would seem unsolvable. Some economists think that as a result,
the government should give up on attempts at month-to-month
management of the economy and concentrate instead on providing a
stable monetary environment in which wage and price setters can
make decisions. They think that attempts to "fine tune" the
economy will make things worse, increasing the variability of
employment and, ultimately, the price level. Other economists
disagree, arguing that economists have some (albeit an imperfect)
capacity to engineer greater stability of output and employment.
This brings us to a further problem. The government hires its economists
from the same employment pool as does the private sector. Why should
economists working for the government be better able to predict the future
than those working for private firms? If the government has the same
information as the private sector, there is no way it can make things
better by conducting countercyclical policy. The private sector will
automatically take into account what it knows in setting wages and prices.
If the government could predict that those settings are wrong, so
could the private sector, in which case the private sector would
have made more appropriate wage and price settings in the first
place.
When the government indeed has better information than the
private sector, there is a simple no-nonsense way to deal with
the situation---simply publish that information. Wage and price
setters will then take it into account in their decisions and
prospective deviations of employment from its normal level will
be avoided as much as possible. If the government continuously informs
the private sector of everything it is doing, private wage and price
setters will take account of the effects of the government's actions in
their wage and price setting decisions. Those decisions would
have been designed to produce full employment in the absence of
the government actions and, taking into account those actions,
will still be designed to produce full employment. As long as
the private sector has the same information about the future
course of events as does the government, the actions of the government
will have no cyclical effect on private-sector employment. Private decision
makers would otherwise have compensated for the absence of those
government actions when setting wages and prices.
If the government conducts policy in secret, its policies
will add random variability to the economy when the information
on which they are based is no better than that available to the
private sector. The government is creating variations in aggregate
demand that are unknown to the private sector and, hence,
cannot be taken into account in private wage and price settings.
On the other hand, when the government has information that the
private sector does not have, its policies will simply do what
the private sector would have done on its own had the government
made its superior information publicly available. This argument that
government counter-cyclical policy cannot usefully affect the economy
is called the 'policy irrelevance proposition'.
But this policy irrelevance argument assumes that private
wage and price setters are able to change wages and prices
quickly in response to new information. When they lock themselves
into contracts extending over several periods, such wage
and price adjustments will not be possible even if everyone knows
they should be made. In this case the government can improve the
situation even when its information about the economy is the same
as that of the private sector. It can adjust the money supply
(only under flexible exchange rates if the country is small) to shift aggregate demand to
exactly compensate for the private sector's inability to adjust
wages and prices. These contractual rigidities are likely to be important
when the economy has been on a stable path for a long time and
periodic costs of renegotiation can usefully be avoided by
setting long-term contracts. When there is a lot of variability
in aggregate demand, however, it is in the interest of contracting parties
to make more frequent shorter-term contracts so that adjustments to take
new information into account can be made quickly.
Rational expectations means that people take all available information into
account in making market decisions. In the computer-assisted learning
modules Asset Markets and The Foreign Exchange
Market, rational expectations meant that markets were
efficient---that market prices reflected all available information
about future asset returns. In the above discussion we have shown that
analogous arguments can be made about labour markets.
Time for a test. Be sure to think up your own answers before looking at the
ones provided.
Throughout this series of computer-assisted learning modules dealing
with small open economy equilibrium we have alternated between two
crude assumptions about wage and price level adjustment. We either
assumed that wages and prices adjust instantaneously in response
to supply and demand forces and the economy is continuously at
full employment, or we assumed that wages and prices are rigid
and variations in aggregate demand lead entirely to adjustments
of output and employment. Along the way we have noted that
prices will adjust in the long-run but not the short-run but have
been somewhat casual in stating how and why. We now clean up
this loose end and explore more fully the implementation of
countercyclical government policy.