Topic 7. Rational Expectations and Monetary Policy

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.

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.

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