You can fool some of the people all of the time, and all of the people some of the time, but you can't fool all of the people all of the time.                        Abe Lincoln

You can fool some of the people all of the time, and all of the people some of the time, and them's pretty good odds.                 Brett Maverick (a 1950s TV western)

Another challenge to demand-management policies has been issued by new classical macroeconomists who doubt that activist macroeconomic policies will work consistently, if at all. Their predictions are based on theories about competitive markets.

Competitive Markets

 

The theory of competitive markets is predicated on a number of assumptions. The most important of these for analyzing macroeconomic policy are:

1.         Market participants have perfect information about all potential transactions.

2.         Transportation costs are zero, so all goods and resources can move freely and instantaneously between markets.

3.         Buyers try to maximize their satisfactions; sellers, their profits; and workers, their net well-being.

4.         All prices are perfectly flexible.

           

            A perfectly competitive economy will operate efficiently at all times because any profit opportunities or opportunities for workers or consumers to improve their welfare will be exploited instantly. The problem posed for activist policymaking is that Keynesian policies work only if an economy is inefficiently operating inside its production-possibilities frontier. If the economy is efficient and at its capacity, active policymaking generates only price adjustments (inflation or deflation), not quantity adjustments (changes in output and employment).

            Equally critical is the fact that fiscal and monetary policies will have different effects in the short run than in the long run only if people are ignorant either about the thrust of policies or their long-run effects. We discussed in the previous section how expansionary or contractionary policies might have different effects in the short run than in the long run. Let us see why perfectly efficient competitive markets might cause long-run adjustments to occur instantly when demand-management policies are used.

Efficient Markets

 

Efficient markets theories suggest that activist policymakers try to fool people in the fashion of riverboat gamblers, but these policies do not work because Lincoln was a better observer of human nature than was the scriptwriter who contributed Maverick's famous line. In fact, these modern classically-oriented theorists go beyond Lincoln, asserting that you can't fool all of the people any of the time because markets operate efficiently if substantial information about profit opportunities is widely available.

The efficient markets theory assumes vigorous competition for any ideas or information that might prove profitable. Competition causes any predictable abnormal gain from an investment to be exploited almost instantly.

Profits that might reasonably be expected from some activity will draw alert profit seekers like garbage trucks draw flies. Thus, easily anticipated economic profits will evaporate because of competition. When an attractive investment becomes public knowledge, the cost of investing will be bid up so that only normal returns can be realized. Only above normal profits that reasonable people would not anticipate remain as possibilities. Thus, extraordinarily high returns from an investment are largely a matter of luck.

 

Rational Expectations

 

A close relative of efficient markets theory is the theory of rational expectations. If people's expectations are formed rationally, they will learn to identify the variables that shape the circumstances affecting their lives.

The theory of rational expectations suggests that after policymakers pursue either expansionary or contractionary policies a few times, people learn to predict both changes in policies and in the policies themselves. Consumers and investors will then offset predictable policies, preventing them from having any real effect.

 

            Accordingly, adherents of the rational expectations approach believe that policy goals cannot be achieved, even in the short run, unless the effects of demand-management policies come as complete surprises to the public. Rational expectations theorists believe that predictable policies cannot consistently fool the public. This is a modern extension of the idea that inflation illusion is never permanent.

 

            Natural rate theory is an important cornerstone for rational expectations theory. The concepts of natural rates of interest and unemployment are starting points in exploring the view that demand-management policy is impotent even in the short run. Consider Figure 10. Suppose a heavy short-run dose of expansionary monetary policy shifts Aggregate Demand from AD0 to AD1, boosting prices and real output to P1 and Q1 respectively (point b). This drives down unemployment rates and both nominal and real interest rates. When people eventually begin to anticipate inflation, then output, unemployment, and the real interest rate return to their original values while prices and nominal interest rates rise (point c). After this cycle occurs once or twice, most people learn to anticipate it and try to take advantage of their ability to "predict the future."

 

Figure 10  Rational Expectations, Equilibrium Output, and the Price Level

Expansionary policy shifts the Aggregate Demand curve from AD0 to AD1. As both output and the price level rise, people begin to anticipate inflation and take steps to offset the effects of inflationary federal policymaking. Simple natural rate theory would predict a path like a Ò  b Ò  c, while rational expectationists would expect a move directly from a Ò  c as people instantly adjusted to the expansion.

            Suppose you are one of those who have observed this cycle and begin following the FED's policies closely. If increases in the prices of bonds and declines in interest rates invariably follow expansionary monetary policies within a few weeks, then you should make some money if you buy bonds the instant that monetary expansion begins. Since you will be holding bonds when interest rates fall, the increase in bond prices should profit you immensely. (Recall the inverse relationship between bond prices and interest rates.) As you and other "money-watchers" try to put this strategy into practice, the demand for bonds, and hence, their prices, would begin to rise just as soon as expansionary monetary policies are adopted. The short-run lag between expansionary policies and the declining interest rate will collapse to zero---the adjustment becomes instantaneous. In Figure 10, as individuals anticipate the effects of policy, the economy will move directly from point a to point c and Aggregate Output will not change.

 

            This is not, however, the end of the story. In the long run, nominal interest rates presumably rise to reflect inflationary expectations. Therefore, you and all the other "FED watchers" will want to sell all your bonds before interest rates increase. Because the short run is now extremely short, the time to sell bonds is the instant you discern an expansionary policy. Because you will only be one among many unloading bonds when the money supply increases, the almost immediate result of an expansionary monetary policy will be to drive bond prices down and interest rates up in anticipation of inflation. But the story goes on.

 

            If you expect inflation, you (and just about everyone else who is paying attention) will want to spend your money on goods and services while they are still cheap. (Remember, buy low.) If you manage a firm, you will immediately raise prices when monetary expansion begins; higher prices might help you build inventories that will be worth more money if you just wait a bit before you sell. Thus, inflationary policies will cause almost immediate increases in nominal demands for goods and reductions in their nominal supplies.

 

            For those unemployed, inflationary expectations adjust quickly to expansionary policies and they are unwilling to accept a job at lower real wages. Therefore, unemployment will not fall below the natural rate as a consequence of expansionary policy. The end of this rational expectations story is that unless the government disguises its policies, an expansionary policy will almost instantly drive up the price level and nominal interest rates, with little or no effect on employment and output. A reversal of this story can be told for contractionary policies.

 

            Note that one essential difference between the simple natural rate theory and rational expectations theory is the speed with which accurate expectations are assumed to be realized. Simple natural rate analysis would predict a path like aÒ bÒ c in Figure 10, while rational expectationists would expect a direct movement from point a to point c, with no temporary increases in output and employment.

 

 

Limitations of Rational Expectations Theory

 

Just how realistic is rational expectations theory? Most of the population may ignore monetary and fiscal policies, but major economic institutions carefully study government policies in the hopes of predicting future economic activity so they can get the jump on their competition or buffer themselves from hardship. Examples include banks, major corporations, unions, trade groups, and foreign governments. These groups do have substantial resources that can be shifted rapidly whenever the direction of policy seems likely to change. For example, price hikes are common adjustments whenever the imposition of wage and price controls appears imminent.

 

            Other factors, however, may limit the potential impact of rational expectations. First, rational expectations analysis assumes that people are able to accurately forecast government policymaking when it often seems the government is unable to do this itself. Information about government policies is unavoidably expensive and imprecise. As a result, many people remain "rationally ignorant." Critics contend that, in the short run at least, government policy may push employment, prices, and interest rates away from their natural levels.

 

            Second, this theory assumes that many people understand how the economy will adjust to particular policies. Economic forecasters who have studied the economy for years often disagree on paths of economic adjustment. The idea that anyone can systematically forecast the effects of policy with precision is extremely dubious. One reason is that public policy may alter the structure of output. For example, the Clinton administration has slashed defense spending, changing the structure of Aggregate Output. Similarly, expansionary monetary policy may reduce interest rates in the short run, resulting in rising investment that may alter the long-run production possibilities for the economy.

 

            Finally, rational expectations theory assumes that wages and prices are perfectly flexible and adjust instantaneously to market forces. Union contracts, efficiency wages, certain laws and regulations, long-term business contracts, and numerous other obstacles all keep wages and prices from adjusting immediately to changes in Aggregate Demand and Supply. It takes time for private investors and households to (a) recognize that policies and situations have changed, (b) implement plans to reflect new circumstances, and (c) have their new plans take affect. Government policymakers face parallel recognition, administrative, and impact lags. ( These policy lags are discussed in more depth in the next chapter.) All of these reasons cause critics of this version of new classical macroeconomics to believe that short-run macroeconomic movements can be controlled by appropriate policies.

 

 

Real Business Cycles

 

Most economists, whether Keynesian or classically oriented, traditionally viewed business cycles as temporary departures from some long-run trend of economic growth. For more than 60 years, these deviations were viewed as resulting primarily from erratic changes in Aggregate Demand. This focus on Aggregate Demand helps explain why orthodox Keynesians typically argue that fiscal policy offers a cure for business cycles, while most new classical economists favor a stable monetary growth rule, viewing fiscal policy as counterproductive and/or ineffective.

 

            Concentration on Aggregate Demand is viewed as misdirected by real business cycle analysts. This group, a subset of new classical macroeconomists, disputes the assumed transitory nature of business cycles and differs with the traditional view that erratic Aggregate Demand is responsible for changes in economic activity. Real business cycle analysts contend that most fluctuations in real GNP are permanent---not temporary. These economists also contend that shocks to Aggregate Supply are the principal causes of business cycles.

 

            Shocks to the system, according to the theory of real business cycles, are often random and include such events as the introduction of new production techniques (e.g., Henry Ford's assembly line or the Japanese "team" concept), introduction of new products (the steam engine, lasers, and microchips), changes in climatic conditions (freezes, floods, or droughts), new discoveries of basic resources (oil fields in Mexico and Alaska), price shocks for important raw materials (oil price hikes in the 1970s), or widespread changes in life-styles.

 

            For example, consider the negative shock shown in Figure 12. Assume that the shock (e.g., an oil price increase) reduces the economy's productive capacity, thereby reducing labor's productivity. This reduces the demand for labor so less labor is hired, reducing employment and output. Graphically, the Aggregate Supply curve shifts leftward from ASLR0 to ASLR1, and real GNP falls from Qf0 to Qf1. Notice that this shift is permanent unless something pushes Aggregate Supply back to ASf0.

Figure 12  Real Business Cycles

Real business cycle theorists argue that shocks to Aggregate Supply permanently change economic activity. A negative shock (e.g., an oil price hike) would shift Aggregate Supply from AS0 to AS1, lowering employment and output. Changes in technology, productive capacity, and lifestyles are among the primary instigators of business cycles according to real business cycle analysts.

            The policy conclusions of this analysis echo those generated by other new classical models: Government should follow passive policies. If government actively responds to a supply shock with expansionary policies, the end result will merely be increases in the price level. If contractionary policies are pursued in hopes of suppressing cost-push inflationary pressure, the result will be deeper price adjustments than would occur if government policy had remained passive.

 

            Most economists largely reject the real business cycle model for several reasons. First, its advocates have had difficulty in showing that periodic supply shocks have been sufficiently strong to explain cycles that have averaged roughly four years in duration. Second, proponents of real business cycle theory have been unable to connect particular technological events (or shocks) to subsequent business cycles (the lone exception is the 1973--1974 oil price shock). Finally, this theory suggests that negative Aggregate Supply shocks reduce productivity and the demand for labor, thereby reducing real wages. The empirical record of business cycles and wages does not support this chain of events. Nevertheless, this theory has sharpened our focus on linkages between short-term business fluctuations and long-term economic growth.

 

            By now, your head may be spinning with all of the different perspectives of economists about macroeconomics. In Figure 13, we summarize the relative positions of various groups of economists ranging from those who would favor macroeconomic "fine-tuning" to the different strands of the new classical macroeconomics, which are all critical of activist macro policy. Keep in mind, however, that the differences between different schools of thought are less extreme than was true 20 or 30 years ago, and that few economists can be pigeon-holed precisely into any of these schools of thought. Most economists recognize that the world is far more complex than can be summarized by any single theory, and borrow bits and pieces of theory that are in accord with their own individual views of how the world works.

 

            Figure 13  A Continuum of Economists' Views About Policy

 

New classical macroeconomics remains attuned to many laissez-faire policy prescriptions from the classical school, but much of it is at least somewhat influenced by Keynesian insights.  Most new Keynesians, on the other hand, are far less convinced of the efficacy of activist policies than were Keynesians of an earlier era, but they too have been influenced by New Classical analysis.