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: t = -b(yt ² yt-1) + Mt + G + t SRAS: yt = yt-1 + a( t ² Et-1 t) + t Let us assume that G = 0 to simplify the algebra (the result also holds if we assume M = 0)

POLICY INEFFECTIVENESS PROPOSITION

yt ! yt 1a[b( yt  yt 1)(Mt  Qt  Et 1Tt ]It ( yt  yt 1)!ab( yt  yt 1)a[(Mt  Et 1Tt ] aQt It ( yt  yt 1)(1ab)!a[(Mt  Et 1Tt ] aQt It a 1 yt ! yt 1 [(Mt  Et 1Tt ] (aQt It ) 1  ab 1  ab
Output is Output in influenced the previous by: period Something we can·t make sense of ² WHAT is the Expected value of inflation? Random shocks

POLICY INEFFECTIVENESS PROPOSITION
Now we need to TAKE EXPECTATIONS of the AD equation.

Et  1Tt ! b( Et  1 yt  Et  1 yt  1)  Et  1(Mt  Et  1Qt Et  1Tt ! b( Et  1 yt  yt  1)  Et  1(Mt
Et-1yt-1 is yt-1 (as it is already observable, and Et-1 t 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.
t 1 t

y !

t 1 t 1

y 

a(
t 1 t

t 1 t

T
t 1 t

t 1

t 1 t

T)

t 1 t

I

t 1 t

y ! yt  1  a (

T

T)

t 1 t

y ! yt  1

POLICY INEFFECTIVENESS PROPOSITION

Thus throwing it all together:

Et  1Tt ! b( yt  1  yt  1)  Et  1(Mt Et  1Tt ! Et  1(Mt a 1 @ yt ! yt  1  [(Mt  Et  1(Mt ]  [aQt  It ] 1  ab 1  ab
Output is Output in influenced the previous by: period A Policy ¶Surprise·. This could also be a deviation from expected Government expenditure Random shocks

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 Contracts are fixed t t+1

POLICY INEFFECTIVENESS PROPOSITION

Taking off from the previous mathematical derivation, this means: Expected inflation for ¶t·: Et-1 t = Et-1 Mt Expected inflation for ¶t+1·: Et t+1 = Et-1 Mt Therefore (using a different parameter instead of a as wages are fixed): Yt = yt-1 + (f/1+fb)[ Mt - Et-1 Mt ] + (1/1+fb)[f t + t] Yt+1 = Yt + (f/1+fb)[ Mt+1 - Et-1 Mt ] + (1/1+fb)[f t+1 + t+1] We can see that we can sub in Yt into the equation for Yt+1. This means that Yt+1 = g( t , t ) 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.

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