Policy Ineffectiveness Proposition
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The Policy Ineffectiveness Proposition (PIP) is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations. It demonstrated that governments are powerless in the management of output and employment in an economy.
[edit] Critique
The Sargent and Wallace model has been critised by a wide range of economists. There are those, such as Milton Friedman, who question the validity of the assumption of rational expectations. Sanford Grossman and Joseph Stiglitz argue that although agents have the cognitive ability to form rational expectations, they will be unable to profit from the resultant information since their actions will reveal to others the nature of this information. Agents therefore avoid the cost of obtaining the information and allow government policy to remain effective.
The New Keynesian Stanley Fischer (1977) applied the insights of Franco Modigliani to the model employed by Sargent and Wallace. Fischer therefore introduced the assumption that workers sign nominal wage contracts that last for more than one period, wages are "sticky". With this assumption the model shows government policy is fully effective since, although workers rationally expect the outcome of a change in policy, they are unable to respond to it as they are locked into expectations formed when they signed their wage contract. Not only is it possible for government policy to be used effectively, but its use is also desirable. The government is able respond to stochastic shocks in the economy which agents are unable to react to, and so stabilise output and employment.
The Barro-Gordon model showed how the ability of government to manipulate output would lead to inflationary bias. The government would be able to cheat agents and force unemployment below its natural level but would not wish to do so. The role of government would therefore be limited to output stabilisation.
Since it was possible to incorporate the rational expectations hypothesis into macroeconomic models whilst avoiding the stark conclusions that Sargent and Wallace reached, the policy ineffectiveness proposition has had less of a lasting impact on macroeconomic reality than first may have been expected.
[edit] References
- Barro, Robert J. 1977. Unanticipated Money Growth and Unemployment in the United States. The American Economic Review 67, no. 2 (March): 101-115
- Barro, Robert J. 1978. Unanticipated Money, Output, and the Price Level in the United States. The Journal of Political Economy 86, no. 4 (August): 549-580
- Sargent, Thomas, and Neil Wallace. 1976. Rational Expectations and the Theory of Economic Policy. Journal of Monetary Economics 2, no. 2 (April): 169-183
- Glick, Reuven, and Michael Hutchison. 1990. New Results in Support of the Fiscal Policy Ineffectiveness Proposition. Journal of Money, Credit, and Banking 22, no. 3 (August): 288-304
- Grossman, Sanford J. and Stiglitz, Joseph, 1980. "On the Impossibility of Informationally Efficient Markets". American Economic Review 70 (3): 393–408.
- Heijdra, Ben J. and van der Ploeg, F. 2002. Foundations of Modern Macroeconomics
- McCallum, Bennett T. 1979. The Current State of the Policy-Ineffectiveness Debate. The American Economic Review 69, no. 2 (May): 240-245
