MACROECONOMICS: THE

SARGENT & WALLACE POLICY

INEFFECTIVENESS PROPOSITION,
LUCAS CRITIQUE
POLICY INEFFECTIVENESS
PROPOSITION
 ASSUMPTIONS:
 PRICE FLEXIBILITY

 WAGE FLEXIBILITY

 RATIONAL EXPECTATIONS

 Assume the following model of an economy:

 AD: πt = -b(yt – yt-1) + ΔMt + ΔG + μt

 SRAS: yt = yt-1 + a(πt – Et-1πt) + εt

 Let us assume that G = 0 to simplify the algebra (the
result also holds if we assume M = 0)
 POLICY INEFFECTIVENESS
PROPOSITION
yt  yt 1 a[b( yt  yt 1)Mt  t  Et 1t ]t
( yt  yt 1)ab( yt  yt 1)a[Mt  Et 1t ] at t
( yt  yt 1)(1ab)a[Mt  Et 1t ] at t
a 1
yt  yt 1 [Mt  Et 1t ] (at t )
1  ab 1  ab

Output is Output in Something we can’t Random shocks

influenced the previous make sense of –
by: period WHAT is the
Expected value of
inflation?
 POLICY INEFFECTIVENESS
PROPOSITION
Now we need to TAKE EXPECTATIONS of the AD
equation.
Et  1t  b( Et  1 yt  Et  1 yt  1)  Et  1Mt  Et  1t
Et  1t  b( Et  1 yt  yt  1)  Et  1Mt
Et-1yt-1 is yt-1 (as it is already observable, and Et-1μt is zero (as it
is, by definition, RANDOM). We now need to know Et-1yt-1 so
let’s take expectations of the SRAS curve.

Et  1 yt  Et  1 yt  1  a( Et  1t  Et  1Et  1t )  Et  1t

Et  1 yt  yt  1  a( Et  1t  Et  1t )
Et  1 yt  yt  1
 POLICY INEFFECTIVENESS
PROPOSITION
 Thus throwing it all together:

Et  1t  b( yt  1  yt  1)  Et  1Mt

Et  1t  Et  1Mt
a 1
 yt  yt  1  [Mt  Et  1Mt ]  [at  t ]
1  ab 1  ab

Output is Output in A Policy ‘Surprise’. This Random shocks

influenced the previous could also be a deviation
by: period from expected
Government expenditure
POLICY INEFFECTIVENESS
PROPOSITION
 This suggests that Policy makers are ‘impotent’, as only
a ‘surprise’ decision can alter short-run output.
 HOWEVER. We can disprove the PIP by simply
challenging one of the assumptions listed; namely wage
flexibility.
 Let us assume contracts are fixed for 2 periods, that is:

 t-1: Contracts are being negotiated

t

 t+1
Contracts are fixed
POLICY INEFFECTIVENESS
PROPOSITION
 Taking off from the previous mathematical derivation, this
means:
 Expected inflation for ‘t’: Et-1πt = Et-1ΔMt
 Expected inflation for ‘t+1’: Etπt+1 = Et-1ΔMt
 Therefore (using a different parameter instead of ‘a’ as wages
are fixed):
 Yt = yt-1 + (f/1+fb)[ΔMt - Et-1ΔMt ] + (1/1+fb)[fμt + εt]
 Yt+1 = Yt + (f/1+fb)[ΔMt+1 - Et-1ΔMt ] + (1/1+fb)[fμt+1 + εt+1]
 We can see that we can sub in Yt into the equation for Yt+1.
This means that Yt+1 = g(μt , εt )
 Hence, as the market can’t react to the shocks having
occurred in time ‘t’ (due to wages being fixed), there is a
DESIRABLE and FUNCTIONAL role for the Government in
order to react to the shocks (AD shifts).
 We could show that the PIP holds for 1 period fixed contracts.
LUCAS CRITIQUE
 Fundamentally, the Government is impotent. This is
because the Government needs to know the slope of the
AD/AS curves in order to exploit them.
 HOWEVER, because these slopes are DETERMINED
by Government policy, a change in Gov. Policy will also
change the slope.
 Thus, the Government will never be able to know what
to do, as it’s actions alter the means of getting to the
ends.
 This lead to the new Keynesian school of economics
which focuses on microfoundations.