“Monetary policy cannot systematically stimulate the economy
to lower unemployment rates”
That startling claim is one of the consequences of a new view
of economic policy that has been termed, “rational expectations.” This new view attacks widely held beliefs about how the economy
works and challenges many prevailing theories about what economic
policy can achieve.
These new ideas are so fundamentally important to the current
predicament facing our nation's economy and to the future course
of national economic policy that policy makers and the general
public affected by policy makers' choices need to understand
the logic and evidence that support the rational expectations
But most recent work in the theory and in the analysis of
past economic experience—including major contributions made
by the Research Department of this Bank—has been too technical
to be understood by a more general audience. Hopefully this
article will explain the essential ideas of the rational expectations
challenge in fairly simple language. By doing that, we hope
to encourage discussion of rational expectations among elected
officials, policy makers, and a wider public.
We'll begin by briefly defining what we mean by “rational
expectations” and by identifying the kind of policy to which
it applies. Our discussion will then address the following points:
- Why traditional views about how economic policy works are
- Why rational expectations is a valid view of the world,
- What happens when current methods of policy making are used
in a rational expectations world, and
- in the light of rational expectations ideas, what can macroeconomic
policy really hope to achieve?
“Rational expectations”: what it means.
When the term “rational expectations” first appeared in an economic
journal article in 1961, it was given a specific technical meaning
connected with economic models. In an everyday, practical sense
rational expectations is simply an assumption about people's behavior.
The assumption claims that people make economic decisions in a way
that tends to take into account all available information bearing
significantly on the future consequences of their decisions. And
they tend to use that information in a way so as not to repeat their
past mistakes. The information we're talking about can include,
among other things, knowledge about government policy actions already
taken and about strategies or approaches government policy makers
regularly take when economic signals begin to change. So, rational
expectations attributes to people a reasonably thorough, broad view
approach to appraising the future on matters that are going to make
a big dollars-and-cents difference to them.
Put that way, there's certainly nothing startling about the rational
expectations idea. Most of us have believed all along that rationality
in that sense is a reasonable thing to attribute to economic decision
makersbusiness people, labor leaders, workers, investors,
or consumers. What is startling is that the ideas underlying current
policy views deny such rationality. Current views about how policy
achieves its effects depend on people jailing to act in their own
best interests. When we recast the decision-making process to allow
people to act with "rational expectations," policy no longer has
the same effects. And that's the heart of the problem we're examining
in this article.
The importance of expectations in decision making.
All economists agree that people's beliefs about the future affect
their decisions today. Employers and employees negotiate wage contracts
with some picture in mind about what will happen to the cost of
living or to other related wage rates over the life of a contract.
Consumers deciding whether to purchase a car have expectations about
future income, job prospects, future cash outlays, and perhaps sources
of credit in an emergencyif only to judge whether the automobile
installment payments can be met. Similarly, a business firm deciding
whether to invest in new factories must form expectations about
such things as future sales, future labor and other input costs,
and future tax rates.
According to the rational expectations view, people use in the
best way possible whatever information they have; and they do not
tend to repeat previous errors. People are forward looking, and
prospective government actions play an important part in their picture
of the future. The myriad of commercially available newsletters,
analytical reports, and forecasting services reminds us that forecasting
government actions has become big business. And even though people
must make plans in an environment of considerable uncertainty (and,
therefore, are likely to make some mistakes), they do learn to avoid
repeatedly misusing information that will bear on their future.
That's because the economic process rewards those who make good
forecasts and penalizes those who don't.
Types of policies under question.
We should emphasize that the kind of policy making we're looking
at embraces attempts to manage, or influence, demand for goods
and services in order to smooth out the business cycle. Sometimes
these kinds of policies are called demand management policies,
aggregate demand policies, or simply countercyclical policies.
(We'll use these terms interchangeably.)
Virtually everyone who reads the newspapers is aware of the continuing
public discussion of these policies. Government choices regarding
how much it will spend in relation to how much it will tax, when
used as deliberate countercyclical measures, are called fiscal policies.
Decisions by the Federal Reserve to increase or decrease bank reserves,
directed similarly, are called monetary policies. When the federal
government deliberately takes action to spend more than it taxes
away from businesses and individuals, fiscal policy is said to be
expansionary. When the Federal Reserve acts to increase bank reservesa
kind of starter kit for expanded money and credit growth in the
private economymonetary policy is said to be expansionary
and is viewed to be either a complement to expansionary fiscal policy
or a stimulus in its own right. Both of these types of economic
policy are commonly thought to be potent ways to help get a weak
economy moving again.
I. What's wrong with traditional views of the policy process?
Since rational expectations ideas have developed as criticism
of some prevailing ways of viewing the economy and the role of policy,
the case for rational expectations is, to a large extent, the case
against these current views. The traditional views we're talking
about are those claiming that routinely applied fiscal and monetary
stimulus in times of recession, and restraint in times of boom,
will improve the general performance of the economy over the longer
term and make people, on the whole, better off. What we want to
show in the next few sections is that people's expectations, when
formed "rationally," will generally frustrate government's attempts
to successfully pursue activist demand management policies.
We'll do this by outlining the process through which activist
policies are widely believed to get results and show how they depend
on people behaving in ways inconsistent with their own best interests.
Next we'll offer a rational expectations version of the policy process
as a more realistic representation of people's decision making and
indicate how that representation seems consistent with some evidence
from recent experience. We think the rational expectations view
Two stories of how activist countercyclical fiscal and monetary
policies are believed to work will be traced out. In the first
story policy has its effect through the labor market and hinges
on the way labor reacts to changes in wages and prices. The
other story has policy working via financial markets and hinges
on the way changes in interest rates induce (or discourage)
new investment. These two perceptions of the channels connecting
policy with the economic outcome aren't mutually exclusive;
they could easily be combined into a single, more general story.
The stories, though, are often told separately, and since some
of our readers will be more familiar with one or the other it
will be useful to consider each of them in turn. The two perceived
policy channels we are about to consider probably contain the
essence of what most legislator's and policy maker's views depend
on in order for activist policies to get results.
Story one: policy that takes effect through wage decisions.
Central to some widely held views of the policy process are
wage- setting decisions in the labor market. This story, a rather
standard Keynesian one, depends very much on labor not rationally
forming expectations about future conditions at the time wage
contracts are set.
We start with an economy in recession. Government policy makers
want to stimulate hiring and producing by private business firms.
They know the way to get business firms to expand more than already
planned is to take policy actions that will cause business to see
additional profit opportunities. So government increases the amount
of money it spends for goods and services relative to the amount
of money it draws in from the private economy in the form of taxes.
And it creates money to pay for the difference. Prices move up as
business experiences the effects of added spending for its products.
All this time labor is not supposed to look ahead to the end of
the story with its promise of rising prices, and so it continues
to work at very nearly the same old wage. That's what creates new
profit opportunities for business prices for business output go
up, but its major input cost, wage rates for labor, does not. The
outcome: business expands, and as it does it hires more labor.
In this scenario, workers go along with unchanged wage rates
in the face of prospectively higher prices. They find themselves
in the peculiar situation of offering more labor at lower "real-wage
rates," that is, wage rates measured in terms of the amount
of goods they'll buy. That shortsightedness on the part of labor
is crucial if this channel for policy action is to work as claimed.
For if workers bargained for their wages in full anticipation
that prices would rise, or if wages were "indexed" to automatically
follow general price level increases, then that perceived policy
channel would fail to work.
This simplified Keynesian story does no particular violence
to the mechanism many policy activists believe enables government
to start the economic ball rolling. It requires that workers
in the labor market be oblivious to (or largely tolerant of)
the prospect that an unchanging wage along with a rising general
price level will progressively erode the amount of real goods
and services their wages will buy. Since that kind of decision
making hardly seems rational, it's easy to guess the forthcoming
rational expectations criticism.
First, the process will work only if labor does not, in the course
of its wage-bargaining and job-seeking behavior, anticipate the
consequent general rise in prices. It's clear that fiscal and monetary
policies deliberately attempting to stimulate total dollar spending
in the economy would not be able to operate through this price and
wage-setting disparity if those policies were fully predicted or
expected. That's because labor wouldn't willingly or knowingly enter
into a contract that dooms workers to a shrinking real income when
no changes in technology or productivity have occurred that force
upon the whole of the economyowners and managers of business
as well such a real loss in living standards. And in the absence
of that kind of self-diminishing agreement, business would have
no net expansion in profit opportunities to exploit.
Second, any policy process that operates by fooling people as
this Keynesian mechanism certainly requires may work the first time,
but cannot be expected to go on fooling people repeatedly. That's
axiomatic from the rationalists' point of view. Any logical story
of the policy process must grant labor in general and workers in
particular at least reasonable acumen when it comes to making commitments
affecting their personal economic interests. That much is granted
to other actors in the story, of course. Our conclusion then is
that the activist policy process we've been describing will not
bring about any overall real expansion in the private economyunless
it catches people by surprise.
Some indications of labor market response to prospective inflation.
One of the arguments supporters of activist countercyclical
policy make against the rational expectations view starts with
the observation that labor frequently locks itself into contracts
by fixing the course of wages for as much as three years into
the future. That fact, plus perhaps some slowness on the part
of workers in recognizing what's happening to prices in general,
means there's a built-in delay in wage adjustments. But, so
the story goes, product prices can respond quickly to a policy
stimulus, and therefore temporary profit opportunities, at least,
can be created by policy action. That provides incentive for
business to expand, if only temporarily, and thus some potency
is retained by activist policy.
That fragile loophole cannot be relied on in the pursuit of
any systematic countercyclical policy. Contracts are periodically
rewritten and can certainly take into account any earlier misreading
of government policy strategy on the practical principle of
"once burned, twice cautious." One possible response by labor
to being caught short in midcontract because of unpredictable
policy moves by government is simply to shorten the contract
period the next time. That course was pointed out in 1971 by
United Auto Workers President Leonard Woodcock when he said,".
. . if labor contracts can be torn up based upon the stroke
of a pen [a reference to the Wage- Price Freeze on August 15,
1971], then obviously we can no longer in the future negotiate
contracts for any longer than one year.
An alternative response by labor is to stay with longer-term
contracts but base them on a better forecast of inflation. In
fact, the closer labor can come to having wages fully adjusted
for changes in cost-of-living indexes, the closer it comes to
making a "perfect" forecast. That situation, from labor's point
of view, would be the ultimate in rational expectations and
would obviously frustrate the Keynesian policy mechanism described
A telling illustration of the way labor has moved to protect
its real earnings in the recent environment of high price inflation
is the data on the percentage of workers covered by cost-of-living
clauses in their contracts. We've plotted that data in Figure
1. It suggests that labor is in fact responding in a “rational” way to government's continuing failure to deliver on its announced
policy goals for containment of inflation.
Rational Expectations Background to Our Involvement at the Federal Reserve Bank of Minneapolis
While “rational expectations” had appeared as a technical
term in economics literature as early as 1961, the rational
expectations challenge to activist macroeconomic policy theory
is much more recent. And a key element of the challenge was
developed at the Federal Reserve Bank of Minneapolis.
The Bank had, in 1970, launched a major research program exploring
how best the Federal Open Market Committee (FOMC) should make
monetary policy. In 1970 and 1971, respectively, Neil Wallace
and Thomas Sargent, professors of economics at the University
of Minnesota, joined the Bank's research department as economic
advisors to assist in that program. While the program was underway,
a seminal result appeared in a 1972 paper by economist Robert
E. Lucas. Lucas, then at Carnegie Mellon University, had developed
a rational expectations model of the business cycle. The theoretical
importance of his work can hardly be overstated: for the first
time, business cycles could be explained using a model consistent
with the core of standard economic theory.
Rational expectations was quickly seen by Sargent and Wallace
to be of great importance to the research program being carried
on at the Federal Reserve Bank of Minneapolis, particularly as they
began to flesh out the policy implications of Lucas' model. They
found that rational expectations could deprive activist macroeconomic
policy of any systematic real effects. Their findings meant that
activist monetary policy by the Federal Reservetightening
the money supply to cool an overheated economy or expanding the
money supply to stimulate a lagging economymight not work
in the way it had long been believed to be effective. Subsequent
research by Sargent and Wallace has established them, with Lucas,
as the leading theorists of the new view.
To extend discussion of the rational expectations view, the Bank
has sponsored a number of conferences and seminars, publishing papers
and proceedings from those conferences and seminars. In 1974, the
Bank sponsored a conference on the rational expectations challenge
to current policymaking procedures, inviting several of the leading
scholars on both sides of the emerging debate. In June of 1975 we
published Sargent and Wallace's paper, Rational Expectations and
the Theory of Economic Policy, from the 1974 conference as the second
edition in our Studies in Monetary Economics (SME) Series. The third
publication in our SME Series, Rational Expectations and Theory
of Economic Policy: Arguments and Evidence by Sargent and Wallace,
came out of a series of seminars on FOMC policymaking conducted
in 1975 by the Bank's research staff. Further work by various research
staff members on the rational expectations challenge was published
in 1976 as A Prescription for Monetary Policy. In 1977,
the Bank published proceedings of a 1975 conference on business
cycle research, New Methods in Business Cycle Research,
that related to our rational expectations work.
The Bank is continuing its program of fundamental studies
of requirements for optimal monetary policy, with current emphasis
on clarifying the foundations of money in rational expectations
models. A conference of leading scholars dealing with that topic
has been planned for the fall of 1978.
Story two: countercyclical policy that takes effect by
way of interest rate channels.
Now let's look at another commonly held notion of how monetary-fiscal
stimulus makes things move. This one operates through a different
market, the market for investment funds, and seems to depend
on a kind of shortsightedness by suppliers of funds regarding
their prospective “real” interest earnings. The earnings-versus-inflation
discrepancy that policy appears to exploit here parallels labor's
“illusion” about its wage in the first story. According to this
policy story, policy makers' actions to expand the rate of money
growth will influence business expansion decisions and consumer
spending decisions through interest rates.
The story goes as follows.
Start with the perception that the economy is in, or going
into, a recession. Policy authorities act to expand the money
supply growth rate. The Federal Reserve does this by stepping
up its buying of securities from the public (through a network
of dealers in New York). By that deliberate action the public
ends up with a flow of new cash, and banks end up with a flow
of new reserves that enable them to expand loans to businesses,
if they can find customers, by several times the amount of the
Other things being equal, the buying action of the Fed drives
securities prices up, and that means interest rates are driven
down on those securities. The subsequent action by banks seeking
to make loans at a faster pace than they would have done otherwise,
or to buy bonds in greater volumes than they would have done
otherwise, helps move still other interest rates down.
In the next step, business firms expand investment in new production
facilities. One way to imagine why they would do so is to consider
interest on borrowed business funds as simply another cost of doing
business, just as wages for labor inputs are a cost of doing business.
As expectations adjust to the prospect of lower interest costs,
some investment possibilities not previously viewed as profitable
will suddenly appear profitableexpected revenues don't change,
but expected costs go down because the interest cost component has
gone down. Thus, plant and equipment investments are undertaken,
new workers are hired, and new output is produced.
The last step in the story simply recognizes that the added
new workers start some new spending of their own, which further
raises demand, causing additional businesses to expand their
output, and so on. Thus, national product expands by some multiple
of the initial investment stimulus, and we've succeeded in bringing
about large real effects on the economy through small changes
in monetary policy.
Once this process gets underway (plant expansion, new hiring,
and all that), the increased private spending would, just as in
the first story, likely bring forth some mixture of price increases
and real quantity increases in the flow of goods and services. This
story seems even to allow wage rates to be bid up approximately
in line with prices as expansion moves along. The prospect of wage
rate increases can be a part of business firms' expectationsas
long as the necessary capital funds have been or can be acquired
through borrowing at bargain interest rates.
Interest rate responses to monetary-fiscal actions appear to be
the crucial link in the story we've just told. Interest rate responses
also seem to provide the main channel through which monetary policy
actions affect employment and output in the large macroeconometric
models of the United States economy currently used by government
to assist in determining policies and by business to assist in determining
its strategies. The large multi-equation “MPS” model developed by
the Federal Reserve, Massachusetts Institute of Technology, University
of Pennsylvania, and the Social Sciences Research Council has five
directly defined channels that depend on interest rate movements.
Some dozen different interest rates appear in the equations to help
generate quarter-by-quarter predictions of total spending for such
categories as consumer durables, automobiles, producers' durable
equipment, and residential construction. The interest rate linkage
seems also to be a key part of the looser and more generalized anecdotal
story that you might get if you asked some policy makers how their
decisions affect the economy.
In the rational expectations view, however, those stories
are wrong. The interest-rate-link story doesn't take a broad
enough perspective and doesn't adequately accommodate the way
people rationally form their expectations. While it's undeniable
that Federal Reserve action to buy securities and expand bank
reserves results in bidding interest rates down, that response
is temporary and fleeting. The point is that rational lenders
and investors, who look ahead to later chapters of the story,
see that any Federal Reserve push to expand money growth rates
will ultimately raise the growth in the general price level.
Foreseeing that outcome, lenders won't want to tie up funds
in long-term loans at rates of interest which they had calculated
to be acceptable under an outdated view of future inflation.
If they were to commit their funds with no upward adjustment
of their lending rate, they would be agreeing to accept a lower
rate of return in terms of the goods and services they would
subsequently be able to buy. And nothing in the outlook has
changed that should lead them to want to do that.
Instead, they would add an “inflation premium” to the interest
rates they are willing to settle fora little insurance policy
against the heightened prospects for inflation. And interest rate
levels finally settled on in the financial markets have got to reflect
that premium. Finally, if the long-term interest rates relevant
for business capital expansion go up by the full amount of expected
inflation, as the rationalists argue would occur with any foreseen
inflation, all costsincluding interest as a costwill
go up proportionately to the expected price rise so that nothing
will have changed in terms of exploitable profit opportunities.
In short, when policy moves are anticipated or quickly sensed in
market signals, this financial market channel to policy results
we've been describing won't work either.
So what's the evidence that interest rates don't behave as
the conventional policy view would argue they should? Any simple
look at the relationship between money growth and interest rate
levels in the historical record is bound to ignore a lot of
other factors also influencing how those two things behave.
Yet the fact that economic data just don't show high rates of
money growth regularly associated with low levels of interest
rates must, at the very least, raise doubts about the dependability
of that perceived route for policy actions.
You can look at experience across countries [Figure 2a] or over
a period of time within the United States [Figure 2b] and see that
higher interest rates, not lower, appear, if anything, to go along
with higher rates of money expansionprobably reflecting higher
actual and expected inflation rates.
To sum up, the rational expectations view argues that conventionally
perceived policy channelswhether operating through wage costs,
interest costs, or any other market-responsible variableare
wrong because they depend on having people behave contrary to their
own clear best interests, repeatedly neglecting important information
they have or can have about any systematically applied policy.
II. How valid is rational expectations as a representation
of people's behavior?
Some critics argue that rational expectations demands too much
wisdom and perceptiveness of people to be believable. But the validity
of rational expectations does not require that every consumer or
worker or business manager be the “complete seer” of future prices
and other economic events. For example, in the case of wage bargaining
by organized labor, only the union leadership actually engaged in
the bargaining process not each and every rank-and-file memberneed
have an informed view about what government policy is and what its
consequences for future price levels are likely to be. Today's union
leadership, as we pointed out in our review of policy channels in
the previous section, does, in fact, acknowledge its concern about
prospective “real” earnings. Small agricultural enterprises or commodity
dealers need not have specialized resources of their own to forecast
supply and demand movements and toe effects of government policies.
All they need do to learn what the experts are expecting in future
market situations is pick up the newspaper, or the phone, and check
on quoted futures prices or subscribe at modest price to one of
many private newsletters. In the case of small borrowers and investors,
the information possessed by large and sophisticated borrowers and
suppliers of funds becomes very quickly and widely reflected in
publicized interest rates. Studies have shown that financial markets,
including the stock markets, are efficient users of information
in the sense that prices quickly adjust to reflect expert information
on all the factorsgovernment policy included bearing on future
Clearly the major industrial and commercial firms in the economy
have a crucial financial stake in correctly forecasting how
they will be affected by changes in government policy. Any actions
they take, because of changed expectations, in product or resource
markets will quickly carry the message of their reappraisal
to other participants, large and small, on both sides of the
Finally, when wage rates of a particular firm get out of line
with other firms competing for the same labor pool, reaction
by only a few workers is necessary, in general, in order to
cause the firm to adjust its wage rates to the prevailing market.
Perhaps none of the workers need take direct action if the firm
monitors the market and adjusts its salary structure, as many
firms do, using projections based on market surveys. Such surveys
will reflect what's happening at the more responsive firms,
including the effects of escalator provisions and other union
bargaining results. In sum, the rational expectations argument
is that information about the likely future is transmitted in
the marketplace in the same way as information about the present.
A given individual or firm need not be the “complete seer” of
the future any more than of the present.
Some evidence from economic data.
The rational expectations view argues that existing economic
models and theories that have dominated activist policy thinking
for years fail to properly capture the true responsiveness of
real-life decision makers to government policy actions. If that's
true, then the forecasts generated by such models ought to betray
that defect during a period in which policy abruptly changes.
Although traditional models have not been subject to this test
directly, they have been found to be unstable outside the sample
period over which they were estimated.4
The fact that standard models fail in this way suggests that
something is seriously wrong with them. In particular, that
“something” may well be the way in which the economic actors
are represented as forming the expectations on which economic
decision making is based. Traditional models seem to limit too
rigidly the capacity granted to their implicit decision makers
to judge and react to new information.
But what does the test of recent history have to say about how
well rational expectations performs as a model of people's real-life
decision process for the economy as a whole? The technical definition
of rational expectations can be viewed as a very strict assumption
extreme, as some critics contendabout the knowledge and perceptiveness
people have regarding what's happening in the economy. Yet, in another
study, Thomas Sargent 6 has shown that a rational expectations
version of a macroeconomic model, even though built upon extreme
assumptions about the way people see through policy actions, was
not at all inconsistent with data from the United States economy.
The data used reflected, of course, expectations people actually
held and decisions people actually made. From a scientific point
of view, passing such a test doesn't prove that the rational expectations
view is the correct one. The strict form of rational expectations
model used by Sargent merely survives as one legitimate candidate
in a contest that may never be fully decided from the historical
But other new research has extended in a broader framework
the basic rational expectations insights into economic policy
making and the policy-neutralizing effect of people's economic
Support from developments in theory: the new view and the Phillips
Significant support for the credibility of rational expectations
comes from new work incorporating rational individual agents
into a more broadly integrated economic model that exhibits
business cycles and explains the so-called Phillips curve. No
previous theory in economics has managed to perform that job
satisfactorily. Since the Phillips curve is part of activist
policy lore, we want to briefly sketch what the new view has
to say about it.
In the long historical record, high rates of inflation have
tended to go with high rates of employment, and low rates of
inflation have tended to go with low rates of employment. That
kind of relationship is often referred to as a Phillips curve
after economist A. W. Phillips, who in 1958 first described
a connection between unemployment rates and wage-inflation rates
in British data.
To many policy activists the Phillips relationship offers
some hard empirical data tracing out various combinations of
labor market conditions and inflation pressures that correspond
to and support the Keynesian policy stories we've discussed.
In a famous 1960 article, economists Paul Samuelson and Robert
Solow 5 described the observed relationship in the United
States data as a “menu of choice” available to the policy maker.
Until recently the Phillips curve has been widely accepted and
defended as a practical measure of the “trade-off” between national
employment objectives and inflation objectives.
But the Phillips curve relationship is no longer regarded as a
stable or dependable one. If a regular trade-off can even be deciphered
in recent unemployment inflation data, the inflation “price” for
buying lower unemployment appears to have gone up substantially:
high unemployment rates now go hand in hand with high inflation
rates. Proponents of “rational expectations” interpret the broad
pattern of these resultsthe historical Phillips relationship
(such as it has been) and the recent deterioration of the supposed
trade-offas evidence supporting a model of the economy in
which rational expectations operates.
The new theory being built around rational expectations and some
related ideas does in fact account for historical Phillips curve-like
relationships. And those relationships, as pointed out by Robert
Lucas,3 turn out simply to be the observed facts of the business
cycle. The general price level, output, and employment tend to move
up together as people respond to a rather general misreading of
unanticipated price and demand changes. In the inherently uncertain
environment in which decisions are made, people at first take these
as signals of expanded profit opportunities. Subsequently, the same
three quantities tend to move down together when expansion is discovered
to have overstretched the real level of economic demand. But even
though these economic variables do move together in a more or less
regular wayhence the Phillips curve in the historical datathe
rational expectations view says this relationship can not be regularly
exploited for government policy purposes. For if government tries
to raise employment rates by adding to aggregate demand and expanding
the flow of money, people will quickly incorporate into their expectations
the fact that a more rapidly rising level of prices and wages will
surely follow. Business firms will not then be likely to mistake
the price and demand pressures that soon occur as signals of profit
opportunities (a la the channels described earlier) beckoning them
to expand output and employment.
Although actual data from the economy is very “noisy”meaning
it jumps around a lot from one month or quarter to another in ways
that seem to defy explanationit's possible to see that longer-term
movements in inflation rates and employment rates do conform in
a loose way. Data in Figure 3, taken from the period 1965 to 1977,
show three major upward swings, each of several quarters, that,
loosely speaking, trace a kind of Phillips curve expansionary relationship.
The chart also indicates the deteriorating nature of that relationship.
Each successive upswing seems on average to require higher rates
of general inflation to recapture the same level of the employment
rate as observed in the previous swing. That, according to the rationalists,
may be evidence that people have incorporated into their expectations
the government's inflationary bias of the past decade or longer.
III. What happens to activist macro policy in a rational expectations world?
In earlier sections we reviewed arguments for disbelieving
that macro policy actions can work the way conventional perceptions
say they do, and we presented reasons for thinking that the
kind of world policy makers must deal with is something very
close to a rational expectations world.
The serious problem, then, is the following: If people really
do behave as rational expectations models their behavior, then
many existing beliefs about the results policy can achieve are
incorrect. As we've abundantly stressed already, macro policy
initiatives that people anticipate will be frustrated by the
changes people will then make in their plans. More particularly,
any policy move to stimulate aggregate spending will be largely
dissipated by price rises.
We will graphically illustrate what rational expectations
does to conventional macro policy actions through some comparative
simulations produced by a well-known, small econometric model.
An illustration of the effects of rational
expectations on economic policy.
Econometric models are constructed of mathematical equations,
often designed to be solved on computers in a way capable of simulating
the future course of an economy. Results can then be cranked out
quarter- by-quarter to produce numerical forecasts of employment,
prices, or whatever economic variables are contained in the model.
It's now a commonplace that models of this sortsome with as
many as several hundred equationshave since the mid-1960s
become increasingly important information bases for business decision
making and for government policy decision making.
Conventional policy transmission channels, such as the wage illusion
described in section I, are also built into traditional econometric
models often used as a basis for evaluating alternative policy actions.
Those models, of course, were not designed to reflect rational expectations,
but there generally is a way to impose on them a form of rational
expectations. When that's done, the revised macro model reveals
that activist economic policy does not have much of an impact on
the economic outcomeapart from what it does to prices. We'll
illustrate that important result in this section.
Getting a handle on expectations.
Structural econometric models are essentially compact ways
of summarizing a particular view of the way people behave. Some
of the equations in a model will therefore attempt to represent
the things people take into account in making decisions to produce,
to work, or to buy and that means their expectations. Interest
rates, for example, are presumably a factor in business decisions
to build new production plants. So an equation designed to predict
how much new plant will be built next quarter or next year will
include variables representing expectations of business managers
and others about future interest rates as one of the quantities
that must be fed into it.
Finding a measure to reflect people's expectations in a model
poses a problem. We know the model will eventually generate its
own results for the path of future values of its economic variablesincluding,
in particular, those variables for which expectations need to be
One very simple way to program the model to form expectations
for, say, future interest rates is to have the model use its own
most recent quarterly value as the expectation for values in all
future quarters. A less simple approach is to use some average of
several recent quarters as a proxy expectation for future interest
rates. That's exactly what most currently used models, including
the large macro models, dosometimes explicitly but often implicitly.
That procedure is termed “adaptive expectations” because of the
way the expectation slowly adjusts after an abrupt change occurs
in the level of actual rates being generated.
One of the consequences of using adaptive expectations is
that values produced for use as the model's expectations about
each successive quarter's interest rate are usually not equal
to the interest rates eventually produced by the model when
it has been run.
Economist John Muth had this discrepancy between adaptive
expectations and model results in mind when he used the term
rational expectations in 1961. He chose to set the expectations
values for variables needed as inputs to various equations so
as to be equal to the final predictions eventually coming out
of the model. And, from a technical standpoint, that's what
the strict form of rational expectations means. Literally, that
definition of rational expectations credited the model's implicit
decision makers with knowing as much about the way the economy
works as is captured in the model itself and with having full
current information about all other economic variables as well
as settings of the policy instruments (government deficit, size
of the money stock, etc.) under policy makers' control. As we
pointed out in section II, that may seem to be asking a lot,
but subsequent ways of incorporating rational expectations into
models have preserved the essential policy consequences of rational
expectations while requiring agents to be less completely knowing
and informed than outlined above.
Now that we've described what rational expectations does technically
in economic models, we'll look at some indicated results of policy
that come from simulations of a version of the St. Louis Federal
Reserve Bank modelwith and without rational expectations.
In the diagrams [Figures 4a and 4b] we show what the original
model says will happen to the unemployment rate and the inflation
rate as two alternative choices for monetary policy are pursued.
The period spanned is first-quarter 1960 through third-quarter
1963, and the common starting observations (unemployment at
5.8 percent and inflation at 2 percent) were approximate values
for early 1960. To obtain the sequence plotted in Figure 4a,
we imposed a 6 percent annual growth rate for money as an expansionary
policy measure and let the model generate the things it determines
internally, including the unemployment rate and inflation rate.
The model then traced out the quarter-by-quarter path for the
two variables as shown in the diagram. That path is suggestive
of a standard Phillips curve policy "trade-off" that associates
lower unemployment rates with higher rates of inflation.
The curve in Figure 4b was similarly obtained, the only difference
being that we used a less expansionary monetary policy assumption
by setting the annual money growth rate at 4 percent.
A policy activist who accepted this standard version of the
St. Louis model as a good representation of the economy might
feel encouraged at the outset of the simulation period that
the unemployment rate could be "engineered" to a lower level
by pursuing expansionary money growth. Moreover, that result
apparently could be achieved fairly quickly at minimal cost
in terms of extra inflation. With a 6 percent money growth rate,
for example, we'd get the unemployment rate down very close
to 4 percent in about five quarters, and that would add only
about half a percentage point to the inflation rate. Using a
4 percent money growth rate over the same five quarters as depicted
in Figure 4b, we would not do quite as well for the unemployment
rate (cutting it only to the 5 percent level), but the inflation
rate would even decline a little. Thus the "menu of choice"
open to the policy maker would be a menu of alternative paths
through time for the economy, and two of the selections are
illustrated in Figures 4a and 4b. A policy maker considering
just these two options might well decide that it's better to
take the faster route toward a 4 percent unemployment objective
given the small additional inflation that would be caused. (Of
course, the policy authority might then need to be prepared
to shift gears to lower money growth rates as the economy neared
the chosen unemployment objective in order to avoid much higher
inflation rates later on.)
Unfortunately, in a world of rational expectations that attractive
kind of policy menu doesn't exist, as we illustrate in Figure
The last panel in Figure 4 repeats the same Policy simulation
as in the first panelmoney growth rate at 6 percentbut
with the model adjusted 50 that price expectations are rational."
(These simulations are taken from a study prepared by Paul Anderson
1 of this Bank's staff.) The resulting path, traced out by the
simulation, shows dramatically accelerating inflation as the main
achievement of expansionary policy. After five quarters, unemployment
is still in the neighborhood of 5 percent, but the inflation rate
has soared to 8.5 percent, and that seems clearly an unacceptable
“trade-off” for public policy.
While this illustration is constructed through the use of
one specific, small econometric model, the same general outcome
would occur using other well-known macroeconomic models, large
and small. These results vividly portray that rational expectations
has a dramatic effect on what economists' models predict the
impact of policy decisions to be on the economy. In a rational
expectations world, economic policy actions simply don't work
the way many people have believed them to work.
Let's be clear about what has been ruled out by the results
we've shown: They rule out any net gains in employment and output
from routine countercyclical policy. That's because people,
on average, can recognize the incipient stages of recession
as well as government policy makers can, and so people will
anticipate the government's stimulative actions as long as those
actions are applied consistently and systematically from one
business cycle to the next.
But not only is that kind of consistent, orderly application
of countercyclical policy ruled out as incapable of improving
levels of real activity in the economy overall, so also are
any aggregate stimulative policy measures that are readily predictable
or are publicly announced. For they, too, will become a part
of people's expectations.
Surprise moves in policy can of course get people to do things
they hadn't otherwise planned to do. Therefore, activist demand
management policy can, if the magnitude of the policy stimulus
exceeds people's expectations, cause an addition to employment
beyond what would have occurred without policy action. But that
qualification should offer no particular encouragement to supporters
of activist policy. For even the theoretical possibility of
repeated escalations of government stimulus must be limited:
First, because people will catch on that escalation has been
adopted as a strategy and build that strategy into their expectations;
and second, because escalating inflation rates and loss of confidence
in government would pose increasingly troublesome problems to
the continuity of government and its policies. The rationalists
see no constructive role for policies that depend on “surprising” or “fooling” people into doing things. We'll consider that issue
a bit more in the last section.
Conventional policy stimulus in a slack economy.
There is a widely held view that says, if the economy is operating
with a great deal of slack, or “excess capacity,” any policy-spending
stimulus will have little effect on prices and will mainly result
in an increased real quantity of output. Only when the economy
nears “capacity” output, claims that view, will extra stimulus
spending fail to bring forth much new physical output and instead
be largely dissipated on price increases. Neither economic theory
nor empirical evidence supports that view.
There is no compelling theoretical reason to believe that
some kind of critical point exists in the economy's overall
scale of operation that abruptly distinguishes price-quantity
responses taking place above that point from those taking place
below. That doesn't mean that physical constraints or bottlenecks
might not occur at the individual plant or industry level to
temporarily block output increases from occurring in response
to stronger demand. But for the economy as a whole, substitution
possibilities are enormous, so spending can shift to other lines
or services where bottlenecks or constraints will not, in general,
be reached at the same time. Thus, the economic concept of aggregate
production suggests only gradual transition of cost, price,
and profitability relationships over the full range of operating
levels for the economy as a whole.
The observed Phillips relationship (see, for example, Figure
3), which does not in general exhibit a sharp bend, provides
a rough, practical verification that such is the case. And that
ought to indicate, to those who still believe in an exploitable
Phillips curve, that the policy maker gets no “free ride” as
the economy expands from its low points in relative operating
There is further empirical evidence to that point: one of
our studies,2 using data for the United States economy, has
shown that the reported capacity utilization rate does not help
explain inflation rates when the effects of other factors bearing
on price changes are analytically separated out. That is, whatever
the cause of price level changes, that cause doesn't appear
to act any differently when excess capacity is high than when
it is low.
It's true that a government monetary or spending stimulus
sometimes will be dissipated nearly totally in price increases.
At other times it will bring forth greater physical quantities
of goods and services but only when accompanied by an increase
in prices. The determining factor between these two alternatives
has nothing to do with “capacity utilization,” but instead depends
on whether or not the stimulus has been anticipated by people
who make buy-and-sell decisions in the economy.
In summary, there is no activist policy at any level of excess
capacity that does not bring forth price increases at the same
time it causes output expansion, and nowhere does the relative
amount of output vs. price response change greatly as “excess
capacity” is used up.
IV. Some conclusions: given the new viewwhat can macroeconomic
policy really do?
The policy view built around rational expectations ideas does
not argue that monetary actions by the Federal Reserve and fiscal
actions by Congress and the Administration can't have an effect
on production and employment. They can and do, but only when
they surprise people.
As we've repeatedly emphasized, a crucial distinction required
by the new view is that between policy actions that are expected
and policy actions that are surprisesonly the latter cause
people to alter their expectations about opportunities for gain
and hence to adjust their planned behavior.
In the case of policy actions that are expected, the new view
argues there is neither an empirical nor theoretical basis for
believing they can be exploited by policy makers for any beneficial
real effect. Included in this category are predictable policies
such as the Federal Reserve's traditional "leaning against the
wind" (which is to say being "extra" restrictive in supplying
reserves when the economy approaches high operating rates and
being “extra” liberal when the economy has begun to slump),
as long as that leaning is done consistently. The only economic
effect of expected policy actions, if on the stimulus side,
would be to boost general inflation.
Policy actions that come as a surprise to people, on the other
hand, will, in general, have some real effects. Policy surprises
cause people to change their plans, because the expectations on
which they based those plans have been jolted. In the technical
literature, much of the defense of activist policy against the rational
expectations attack has hinged on preserving ways in which surprise
could continue to provide workable leverage for the policy maker,
even though decision agents are granted rational expectations. We've
already discussed a few of these argumentsfor one, the idea
that people lock themselves into contracts on prices or wages. This,
activists argue, enables policy makers to use surprise when needed,
by catching people in midcontract, to foster a particular policy
objective. We pointed out in section Il why that argument is faulty.
Another activist idea is that government policy makers have better
information or superior knowledge about how the economy works, and
so they can take an action that people won't catch on to, at least
for a long enough time to enable some policy results. The premise
about superior knowledge in the government sector is clearly faulty,
and section II talked a bit about the efficiency of private sector
These arguments are at best attempts to patch up questionable
policy theory by finding special conditions under which the
policy of “surprise” can be routinely used by government to
smooth out swings in the business cycle. Rationalists doubt,
at one level of questioning, that stabilization efforts based
on surprise really give the policy maker much to work with.
To the extent surprise policy involves a deliberate strategy
of fooling people (in the sense that had the people only known
the truth they wouldn't have done what the government's action
got them to do) it may easily work the first time, but then
fail to be effective the second or third time because people
have escalated their awareness of what government is likely
to do in any given situation. And unless the “surprise-that-works” is later repeated, under similar conditions and in a consistent
and logical way, it is not possible to distinguish government
policy making from a random, or even perverse, game.
At a deeper level, rationalists doubt that it would be wise,
or fair, for the government to attempt “policy by surprise” even if policy makers were sufficiently resourceful to invent
unendingly new surprise ways to boost the money supply and government
One of the most important ideas emerging from the new view,
as we pointed out in section III, is that the “business cycle” might at last be adequately explained as a property of a properly
working market economy. In such a view, individuals are thought
to react to profit incentives and to imperfectly extract information
about those incentives from changes in price signals that are
in part useful information and in part meaningless “noise.” An economic system doing the most efficient possible job of
reading the information being reflected in price signals will
still experience some irreducible business cycle swings. That's
because the economic process contains inherent mechanisms that
convert random shocks on prices into a more persistent, short-term
misreading of changing profit opportunities. When misread by
enough people, that action can stimulate a cumulative swing
in output that will continue until the misreading is realized
and retrenchment sets in. Random shocks to prices and markets
are always with us. Some arise from natural catastrophes or
man-made embargos, but Lucas 3 argues that an important source
of shocks to prices may have been erratic “surprise” actions
by policy makers themselves.
The new view conjectures that some amount of cyclical swing in
production and employment is inherent in the micro level processes
of the economy that no government micro policies can, or should
attempt to, smooth out. Expected additions to money growth certainly
won't smooth out cycles, if the arguments in this paper are correct.
Surprise additions to money growth have the potential to make matters
worse. That's because surprise policies, and the prospect of other
future surprise policies, lead to greater uncertainty in people's
expectations about future prices, wages, and interest ratesand
those are prime ingredients in people's ongoing decision making.
These new theories say the information value of price signals is
eroded by erratic and unpredictable government policy action. Given
the importance to an efficiently working market economy of information
conveyed by prices, the potential of activist general demand policy
to do costly mischief must be considered a serious one. Government's
potential to systematically exploit surprise shocks is drastically
limited in a rational expectations world.
The road ahead. . .
If it's true that traditionally perceived activist policy
goals are unattainable through macroeconomic policy channels,
what goals should guide monetary and fiscal policy? What should
monetary policy try to do?
One strategy that seems consistent with the significant, though
largely negative, findings of rational expectations would have monetary
policy focus its attention on inflation and announce, and stick
to, a policy that would bring the rate of increase in the general
price level to some specified low figure. To be sure, merely to
announce such a policy at this point in time would be a “surprise”
perhaps a rather large one given the past history of policyand
is therefore likely to have, for a period of time, some effects
on the planned level of output and employment. But there's no way
to avoid some lurching when a trajectory is changed. After a period
of adjustment, so we've argued here, a steady and consistent pursuit
of some publicly known, modest growth for the money supply would
not have detrimental effects on employment levels because the general
price level impact of monetary policy would be built into people's
Given that sort of primary dedication to a lower inflation path,
the general objective of monetary policy suggested by rational expectations
ought to be elimination or reduction of uncertainty about the future
general price levelto make it as predictable and dependable
as possible around some low average rate of growth. That course,
rationalists argue, would do more than any alternative macro policy
posture to contribute to long-term steady economic growth and high
While we might have reasonable confidence in the wisdom of
that general strategy, the rational expectations view can offer
little on the question of how best to implement such a policy
operationally. That's one of the unfinished tasks for research.
In the meantime, the broader issues we've raised are topics
for deep reflection and debate by those responsible for designing
and controlling the economic policies of this nation. That's
a responsibility that ought also to concern informed citizens
who, after all, will reap the benefits of good policies and
pay the costs of poor ones.
1 Anderson, Paul A. “Rational Expectations Forecasts From
Nonrational Models,” Journal of Monetary Economics,
2 Bryant, John, James Duprey, and Thomas Supel. Unpublished
memorandum, November 14, 1977, Federal Reserve Bank of Minneapolis.
3 Lucas, Robert E., Jr. “Understanding Business Cycles,” Carnegie- Rochester Conference Series on Public Policy, Volume
5, supplement to Journal of Monetary Economics. North
Holland Publishing Company, 1977.
4 Muench, Thomas J., Arthur J. Rolnick, Neil Wallace,
and William Weiler. “Tests for Structural Change and Prediction
Intervals for the Reduced Forms of Two Structural Models of
the U.S.: The FRB-MIT and Michigan Quarterly Models.” Annals
of Economic and Social Measurement, Vol. 3, No. 3 (July
5 Samuelson, Paul A., and Robert M. Solow. “Problem of
Achieving and Maintaining a Stable Price Level,” American
Economic Review, Vol. 50, No. 2 (May 1960):177-222.
6 Sargent, Thomas J. "A Classical Macroeconometric Model
for the United States," Journal of Political Economy,
Vol. 84, No. 2 (April 1976):207-37.