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deral Reserve Bank of Minneapolis




Annual Report 1977

Rational Expectations —
Fresh Ideas That Challenge
Some Established Views
of Policy Making







Rational Expectations —
Fresh Ideas That Challenge
Some Established Views
of Policy Making

1977 Annual Report
The Federal Reserve Bank of Minneapolis







About This Issue
F u n d a m e n ta l q u estio n s are being asked about the
Federal R e s e r v e S y s t e m : w h o w e are, w h a t o u r m is sion
is a n d h o w w e g o a b o u t a c c o m p l i s h i n g t h a t m i s s i o n .
P r e s u m a b l y , w e e x i s t b e c a u s e w e h e l p t h i n g s t o be
b e t t e r t h a n t h e y w o u l d b e if w e did n o t e x i s t . O u r m o s t
s i g n i f i c a n t o p p o r t u n i t y t o m a k e t h i n g s b e t t e r is in o u r
m o n e t a r y policy role. T h i s B a n k has done p i o n e e ri n g
r e s e a r c h in t h e r a t i o n a l e x p e c t a t i o n s t h e o r y — a t h e o r y
that has profound implications for the conduct of m o n e ­
t a r y pol i c y. B u t t h a t r e s e a r c h h a s n o t r e a l l y b e g u n t o
p e n e t r a t e p o l i c y m a k e r s ' d i s c u s s i o n s o r d e c i s i o n s . If w e
a r e t o “ m a k e t h i n g s b e t t e r , " it wi l l b e n e c e s s a r y n o t o n l y
to tu rn out significant research, but to make the results
of tha t research understandable to wider audiences.
" R a t i o n a l E x p e c t a t i o n s — F r e s h Ideas T h a t C h a l l e n g e
S o m e E st ab l is h e d V i e w s o f Policy M a k i n g , " leads o u r
1977 A n n u a l R e p o r t and re p r es e n ts o u r effo rt to share,
w i t h an i n f o r m e d public and w i t h elected officials and
policymakers, our view of w h a t rational expectations
m e a n s in t h e real world.

^ y y { a

J

M a r k H. W i l l e s
President

H







Contents
Rational Expectations —
Fresh Ideas That Challenge
Some Established Views
of Policy Making
Statement of Condition

1

14

Earnings and Expenses/Volume of Operations 15
Directors and Officers

16,17




Rational Expectations —
Fresh Ideas That Challenge
Some Established Views
of Policy Making

"M o n e t a r y policy cannot sy stem a tica lly stim u late the econom y
to low er u n em p loy m en t rates."
T h a t s t a r t l i n g c l a i m is o n e o f t h e c o n s e q u e n c e s o f a
n e w vie w o f e c o n o m i c policy t h a t has b e e n t e rm e d ,
"r a t io n a l e x p e c t a t io n s . " T h i s n e w v iew a ttack s widely
held beliefs a b o u t h o w t h e e c o n o m y w o r k s and c h a l ­
lenges m any prevailing theories about w h a t economic
policy ca n achieve.
T h e s e n e w i de a s a r e s o f u n d a m e n t a l l y i m p o r t a n t t o
the c u rren t predicam ent facing o u r nation's e co n o m y
and to t h e f u t u r e c o u r s e o f na t i o n a l e c o n o m i c policy th a t
po l i c y m a k e r s — a n d t h e g e n e r a l pu b l i c a f f e c t e d b y p o l ­
icy m a k e r s ' c h o i c e s — n e e d t o u n d e r s t a n d t h e l og i c a n d
evid e nc e t h a t s u p p o r t t he ra ti o na l e x p e c t a t i o n s view.
B u t m o s t r e c e n t w o r k in t h e t h e o r y a n d in t h e a n a l y ­
sis o f p a s t e c o n o m i c e x p e r i e n c e — i n c l u d i n g m a j o r c o n ­
t r i b u t i o n s m a d e by t h e R e s e a r c h D e p a r t m e n t of this
B a n k — has b e e n to o te ch ni ca l to be u n d e r s t o o d by a
m o r e g e n e r a l a u d i e n c e . H o p e f u l l y t h i s a r t i c l e wi l l
e x p l a i n t h e e s s e n t i a l i de a s o f t h e r a t i o n a l e x p e c t a t i o n s
c h a l l e n g e in f a i r l y s i m p l e l a n g u a g e . B y d o i n g t h a t , w e
hope to e n co u rag e discussion of rational expectations
a m o n g elected officials, policy m a k e r s , and a wi der
publ i c.
We ' l l b e g i n b y b r i e f l y d e f i n i n g w h a t w e m e a n b y
" r a t i o n a l e x p e c t a t i o n s " and by iden ti fy in g t h e kind of
po l i c y t o w h i c h it a ppl i e s . O u r d i s c u s s i o n will t h e n
addr ess th e fo llo w in g points:
(I)

W h y trad itiona l v ie ws a b o u t h o w e c o n o m i c policy
w ork s are w ron g,
(II) w h y r a t i o n a l e x p e c t a t i o n s is a vali d v i e w o f t h e
world,
(III) w h a t h a p p e n s w h e n c u r r e n t m e t h o d s o f p o l i c y m a k ­
i n g a r e u s e d in a r a t i o n a l e x p e c t a t i o n s w o r l d , a n d
( I V ) i n t h e l i g h t o f r a t i o n a l e x p e c t a t i o n s i de a s , w h a t c a n
m a c r o e c o n o m i c policy really ho pe to a c h i ev e ?

“Rational expectations”: what it means.
W h e n t h e t e r m " r a t i o n a l e x p e c t a t i o n s " f i r s t a p p e a r e d in
a n e c o n o m i c j o u r n a l a r t i c l e in 1 9 6 1 , it w a s g i v e n a s p e ­
cific te ch n ica l m e a n in g c o n n e c te d w ith e c o n o m ic
m o d el s . In a n e v e r y d a y , pr a c t i c a l s e n s e r a t i o n a l e x p e c ­
t a t i o n s is s i m p l y a n a s s u m p t i o n a b o u t p e o p l e ' s b e h a v i o r .
T h e a s s u m p t i o n claim s th a t people m a k e e c o n o m i c deci­
s i o n s in a w a y t h a t t e n d s t o t a k e i n t o a c c o u n t all a v a i l a b l e
inform ation bearing significantly on the futu re c o n s e ­
q u e n ce s o f th eir decisions. A nd t h e y tend to use th a t
i n f o r m a t i o n in a w a y s o a s n o t t o r e p e a t t h e i r p a s t




m is ta ke s. T h e i n f o r m a t i o n w e 'r e talking a b o u t can
include, a m o n g o t h e r t hi ng s, k n o w l e d g e ab o u t g o v e r n ­
m e n t policy a c tio ns alre ady t a k e n and a b o u t st ra te gi es or
a p p r o a c h e s g o v e r n m e n t policy m a k e r s regularly take
w h e n e c o n o m i c signals begin to c h an g e. So, rational
e x p e c t a t i o n s a t t r i b u t e s to people a re a s o n a b l y t h o r o u g h ,
broad-view approach to appraising the future on m a t­
t e r s t h a t a r e g o i n g t o m a k e a big d o l l a r s - a n d - c e n t s
difference to them .
Put that way, there's certainly nothing startling
a b o u t t h e r a t i o n a l e x p e c t a t i o n s i dea. M o s t o f us h a v e
b e l i e v e d all a l o n g t h a t r a t i o n a l i t y i n t h a t s e n s e is a r e a ­
s o n ab le t hi ng to a t t r i b u t e to e c o n o m i c decision m a k e rs
— b u s i n e s s people, labo r leaders, w o r k e r s , in v e sto rs , or
c o n s u m e r s . W h a t is s t a r t l i n g is t h a t t h e i de a s u n d e r l y i n g
c u r r e n t policy v ie w s d e n y s uc h rationality. C u r r e n t
v i e w s a b o u t h o w p o l i c y a c h i e v e s its e f f e c t s d e p e n d o n
p e o p l e failin g t o a c t in t h e i r o w n b e s t i n t e r e s t s . W h e n w e
re c a st t h e d e c i s i o n - m a k i n g pr o c e ss to allow people to act
w it h " r a t i o n a l e x p e c t a t i o n s , " policy no lo ng er has the
same effects. And that's the hea rt of the problem we're
e x a m i n i n g in t h i s a r t i c l e .

The importance of expectations in decision making.
All e c o n o m i s t s a g r e e t h a t p e o p l e ' s b e l i e f s a b o u t t h e
f u t u r e a f f e c t th e i r decisio ns today. E m p l o y e rs and
em p lo y e e s n e g oti a te w a g e c o n t r a c ts w ith s om e picture
in m i n d a b o u t w h a t wi l l h a p p e n t o t h e c o s t o f l i v i ng o r t o
o t h e r r e l a t e d w a g e r a t e s o v e r t h e l ife o f a c o n t r a c t .
C o n s u m e r s deciding w h e t h e r to p u rch ase a car ha ve
expectations about fu tu re income, job prospects, future
c a s h o u t l a y s , a n d p e r h a p s s o u r c e s o f c r e d i t in a n e m e r ­
g e n c y — if o n l y t o j u d g e w h e t h e r t h e a u t o m o b i l e i n s t a l l ­
m e n t pa y m e n ts can be met. Similarly, a business firm
d e c i d i n g w h e t h e r t o i n v e s t in n e w f a c t o r i e s m u s t f o r m
e x p e c t a t i o n s a b o u t s u c h t h i n g s as f u t u r e sales, f u t u r e
labo r and o t h e r input cos ts , and f u t u r e tax rates.
A c c o rd in g to t h e ra ti ona l e x p e c t a t i o n s view, people
u s e in t h e b e s t w a y p o s s i b l e w h a t e v e r i n f o r m a t i o n t h e y
have; and t h e y do n o t tend to r ep eat prev io us e rro rs.
People are forw ard looking, and prospective g o v e rn ­
m e n t a c t i o n s pl a y a n i m p o r t a n t p a r t in t h e i r p i c t u r e o f
t h e f u t u r e . T h e m y r i a d o f c o m m e r c i a l l y ava il abl e n e w s ­
l e tt e rs , ana lytica l r e p o r t s , and f o r e c a s t i n g services
r e m in d s us th a t f o r e c a s t i n g g o v e r n m e n t ac tio ns has
b e c o m e bi g b u s i n e s s . A n d e v e n t h o u g h p e o p l e m u s t

1

m a k e pl a ns in a n e n v i r o n m e n t o f c o n s i d e r a b l e u n c e r ­
tainty (and, t h e r e f o r e , a re likely to m a k e s o m e m i s ­
takes), t h e y do le ar n to avoid re p e a t e d ly m i s u s in g i n f o r ­
m a t i o n t h a t wi l l b e a r o n t h e i r f u t u r e . T h a t ' s b e c a u s e t h e
economic process rewards those w h o make good f o r e ­
casts and pe nalizes t h o s e w h o don't.

Types of policies under question.
W e should e m p h a s i z e t h a t t h e kind o f policy m a k in g
w e'r e lo ok in g at e m b r a c e s a t t e m p t s to m a n a g e , or i n fl u ­
ence, d e m a n d f o r go o d s and s erv ic es in o r d e r to s m o o t h
o u t t h e b u s i n e s s c y c l e . S o m e t i m e s t h e s e k i n d s o f po l i c i e s
a r e c a l l e d dem and m anagem ent po l i c i es , aggregate d em a n d p o l ­
icies, o r s i m p l y countercyclical po l i c i e s . ( We ' l l u s e t h e s e
terms interchangeably.)
V i r t u a l l y e v e r y o n e w h o r e a d s t h e n e w s p a p e r s is
a w a re o f t h e c o n t i n u i n g public d isc u ssi o n o f t h e s e pol­
icies. G o v e r n m e n t c h o i c e s r e g a r d i n g h o w m u c h it wi ll
s p e nd in r e l a t i o n t o h o w m u c h it wi ll t a x , w h e n u s e d as
d e l i b e r a t e c o u n t e r c y c l i c a l m e a s u r e s , a r e c a l l e d fiscal
pol i ci es . D e c i s i o n s b y t h e F e d e r a l R e s e r v e t o i n c r e a s e o r
d e c r e a s e b a n k r e s e r v e s , d i r e c t e d s i m i l a r l y , a r e c al l e d
monetary po l i c i es . W h e n t h e f e d e r a l g o v e r n m e n t d e l i b e r ­
a t e l y t a k e s a c t i o n t o s p e n d m o r e t h a n it t a x e s a w a y f r o m
b u s i n e s s e s a n d i n d i v i d u a l s , f i sc a l p o l i c y is sai d t o b e ex p a n ­
sionary. W h e n t h e F e d e r a l R e s e r v e a c t s t o i n c r e a s e b a n k
r e s e r v e s — a k i n d o f s t a r t e r ki t f o r e x p a n d e d m o n e y a n d
c r e di t g r o w t h i n t h e p r i v a t e e c o n o m y — m o n e t a r y po l i c y
is said t o b e expansio nary a n d is v i e w e d t o b e e i t h e r a c o m ­
p l e m e n t t o e x p a n s i o n a r y f i s c a l p o l i c y o r a s t i m u l u s in its
o w n right. B o t h of t h e s e t yp es o f e c o n o m i c policy are
c om m o n ly th o u g h t to be p o te n t ways to help get a w eak
e c o n o m y m o v i n g again.

I. What’s wrong with traditional views
of the policy process?
S i n c e r a t i o n a l e x p e c t a t i o n s i de a s h a v e d e v e l o p e d as c r i t i ­
cism of s o m e preva ili ng w a y s o f v ie w i n g t h e e c o n o m y and
t h e r o l e o f po l i c y , t h e c a s e f o r r a t i o n a l e x p e c t a t i o n s is, t o
a large e x t e n t , th e ca se a ga ins t t h e s e c u r r e n t views. T h e
traditional views w e're talking a b o ut are tho se claiming
t h a t r o u t i n e l y a p p l i e d f i sc a l a n d m o n e t a r y s t i m u l u s in
t i m e s o f r e c e s s i o n , a n d r e s t r a i n t i n t i m e s o f b o o m , wi l l
improve the general p e rfo rm a n c e of the e c o n o m y over
th e l o n g e r t e r m and m a k e people, o n t h e w h o l e , b e t t e r
o f f . W h a t w e w a n t t o s h o w i n t h e n e x t f e w s e c t i o n s is
tha t people's e x p e c t a t i o n s , w h e n f o r m e d " r a t i o n a l l y , "
wi ll g e n e r a l l y f r u s t r a t e g o v e r n m e n t ' s a t t e m p t s t o s u c ­
c e s s f u l l y p u r s u e a c t i v i s t d e m a n d m a n a g e m e n t po l i c i e s .
We 'l l do t h i s b y o u t l i n i n g t h e p r o c e s s t h r o u g h w h i c h
activist policies ar e wi de ly belie ve d to g e t re s u l t s and
s h o w h o w t h e y d ep en d o n people b e h a v i n g in w a y s
i n c o n s i s t e n t w i t h t h e i r o w n b e s t i n t e r e s t s . N e x t we ' l l
o f f e r a ra ti o na l e x p e c t a t i o n s v e r s i o n o f t h e policy p r o c ­
es s as a m o r e r ea l i s t i c r e p r e s e n t a t i o n o f p e op l e ' s d e c i ­
sion m a k in g and indicate h o w t h a t r e p r e s e n t a t i o n s e e m s


2


con sisten t with som e evidence fro m recent experience.
W e t h i n k t h e r a t i o n a l e x p e c t a t i o n s v i e w is p e r s u a s i v e .
T w o s t o r i e s o f h o w a c t i v i s t c o u n t e r c y c l i c a l f i s c al
a n d m o n e t a r y po l i c i es a r e b e l i e v e d t o w o r k wi l l b e t r a c e d
o u t . In t h e f i r s t s t o r y policy h a s its e f f e c t t h r o u g h t h e
labor m a rk e t and hinges on the way labor reacts to
c h a n g e s in w a g e s a n d pri ces . T h e o t h e r s t o r y h a s policy
w o r k i n g vi a f i n a n c i a l m a r k e t s a n d h i n g e s o n t h e w a y
c h a n g e s in i n t e r e s t ra t e s in d uc e (or d isc ou rag e) n e w
inv estm en t. T h e s e tw o perceptions of the channels c o n ­
n e c tin g policy w ith th e e c o n o m ic o u t c o m e a r e n 't
m u t u a ll y exclusive ; t h e y could easily be c o m b i n e d int o a
single, m o r e g e n e r a l s to ry . T h e stor ies , t h o u g h , are
o f t e n t o l d s e p a r a t e l y , a n d s i n c e s o m e o f o u r r e a d e r s wi l l
b e m o r e f a m i l i a r w i t h o n e o r t h e o t h e r it wi l l b e u s e f u l t o
co n si d e r e a ch o f t h e m in t u r n . T h e t w o perce ive d policy
channels w e are about to consider probably contain the
e s s e n c e o f w h a t m o s t legislator's and policy m a k e r' s
v i e w s d e p e n d o n i n o r d e r f o r a c t i v i s t po l i c i es t o g e t
results.

Story one: policy that takes effect th ro u g h w a g e decisions.
C e n t r a l to s o m e widely held v ie w s o f t h e policy p ro c e ss
a r e w a g e - s e t t i n g d e c i s i o n s in t h e l a b o r m a r k e t . T h i s
story, a ra th e r standard K e y n e sia n one, depends very
m u c h o n l a b o r not r a t i o n a l l y f o r m i n g e x p e c t a t i o n s a b o u t
f u t u r e c o n d i t i o n s a t t h e t i m e w a g e c o n t r a c t s a r e set.
W e st a r t w it h an e c o n o m y in r ecess io n . G o v e r n ­
m e n t policy m a k e r s w a n t to s t i m u l a t e hi ri ng and p r o ­
ducing by private business firms. T h e y k n o w the way to
g e t b u s i n e s s f i r m s t o e x p a n d more t h a n a l r e a d y p l a n n e d is
t o t a k e p o l i c y a c t i o n s t h a t wi l l c a u s e b u s i n e s s t o s e e a d d i ­
tional profit op po rt u nitie s. S o g o v e r n m e n t i ncre as es the
a m o u n t o f m o n e y it s p e n d s f o r g o o d s a n d s e r v i c e s r e l a ­
t i v e t o t h e a m o u n t o f m o n e y it d r a w s in f r o m t h e p r i v a t e
e c o n o m y i n t h e f o r m o f t a x e s . A n d it c r e a t e s m o n e y t o
p a y f o r t h e d i f f e r e n c e . P r i c e s m o v e u p as b u s i n e s s e x p e ­
r i e n c e s t h e e f f e c t s o f a d d e d s p e n d i n g f o r i t s p r o d u c t s . All
t h i s t i m e l a b o r is n o t s u p p o s e d t o l o o k a h e a d t o t h e e n d o f
t h e s t o r y w i t h i t s p r o m i s e o f r i s i n g p r i c e s , a n d s o it c o n ­
t i n u e s t o w o r k a t v e r y n e a r l y t h e s a m e ol d w a g e . T h a t ' s
w h a t creates n e w profit opportunities for b u sin e ss—
p r i c e s f o r b u s i n e s s o u t p u t g o up , b u t i t s m a j o r i n p u t c o s t ,
w a g e ra tes fo r labor, does not. T h e o u t c o m e : bus in e ss
e x p a n d s , a n d a s it d o e s it h i r e s m o r e l a b o r .
In t h i s s c e n a r i o , w o r k e r s g o a l o n g w i t h u n c h a n g e d
w a g e ra t e s in t h e face o f p ro s p e ct i v e ly h i g h e r prices.
T h e y fi nd t h e m s e l v e s in t h e p e c u l i a r s i t u a t i o n o f o f f e r ­
i n g m o r e l a b o r a t l o w e r " r e a l - w a g e r a t e s , " t h a t is, w a g e
r a t e s m e a s u r e d in t e r m s o f t h e a m o u n t o f g o o d s t he y' ll
b u y . T h a t s h o r t s i g h t e d n e s s o n t h e p a r t o f l a b o r is c r u c i a l
if t h i s c h a n n e l f o r p o l i c y a c t i o n is t o w o r k as c l a i m e d . F o r
if w o r k e r s b a r g a i n e d f o r t h e i r w a g e s i n f ul l a n t i c i p a t i o n
t h a t p r i c e s w o u l d r i se , o r if w a g e s w e r e " i n d e x e d " t o

a u t o m a ti c a l l y f o l l ow g e n e r a l pri ce level i n c r e a s e s , t h e n
t h a t perce i ved policy c h a n n e l wo ul d fail to wo r k .
T h i s simplified K e y n e s i a n s t o r y doe s no pa r t i c ul a r
v i ol e nce to t h e m e c h a n i s m m a n y policy a ct i vi s t s b el ieve
e n a b l es g o v e r n m e n t to s t a r t t h e e c o n o m i c ball rolling. It
r e qu i r e s t h a t w o r k e r s in t h e l a b o r m a r k e t be obli vi ous to
(or l argel y t o l e r a n t of) t he p r o s pe c t t h a t an u n c h a n g i n g
w a g e a l ong w i t h a ri sing g e n e r a l price level will p r o g r e s ­
sively e r o d e t h e a m o u n t o f real goo ds and s e r vi ce s t he i r
w a g e s will buy. S i n c e t h a t kind of deci s i on ma k i n g
hardl y s e e m s r at i onal , it's e a s y to g u e s s t h e f o r t h c o m i n g
rat i onal e x p e c t a t i o n s cri t i ci s m.
Fi rst, t h e p r o c e s s will w o r k onl y if l a bor does n ot , in
t h e c o u r s e o f i ts w a g e - b a r g a i n i n g a n d j o b - s e e k i n g
b e h a v i o r , ant i ci p a t e t h e c o n s e q u e n t g e n e r a l rise in
prices. It's cl ear t h a t fiscal and m o n e t a r y policies d e l i be r ­
atel y a t t e m p t i n g to s t i m u l a t e t otal dollar s pe ndi ng in t h e

e c o n o m y wo ul d n o t be able t o o p e r a t e t h r o u g h this
pri ce- and w a g e - s e t t i n g di spari ty if t h o s e policies w e r e
fully pred icted or e x p e c te d . T h a t ' s b ecau se labor
wo ul dn ' t wil li ngly o r k n o w i n g l y e n t e r i nto a c o n t r a ct
t h a t d o o m s w o r k e r s t o a s h r i n k i n g real i nc o me w h e n no
c h a n g e s in t e c h n o l o g y or pr o d u c t i vi t y ha ve oc c u r r e d
t h a t f o r c e up o n t he w h o l e of t h e e c o n o m y — o w n e r s and
m a n a g e r s o f b u s i n e s s as w e l l — s u c h a real loss in living
s t a nda r ds . And in t h e a b s e n c e o f t ha t kind of selfd i mi ni shi ng a g r e e m e n t , b u s i n e s s woul d ha v e no net
e xp a n s i o n in prof i t o p p o r t u n i t i e s to exploit.
S e c on d , a n y policy pr o c e s s t h a t op e r a t e s by fool ing
pe opl e — as this K e y n e s i a n m e c h a n i s m ce rt a i nl y requi res
— m a y w o r k t h e f i r s t t i me, b u t c a n n o t be e x pe c t e d to go
on fool i ng peopl e r e pe a t edl y. T h a t ' s a x i o ma t i c f r o m the
ra t i ona l i s t s ' po i nt o f vi ew. A n y logical s t o r y of t he pol­
icy p r o c e s s m u s t g r a n t l a bor in g e n e r a l and w o r k e r s in

Rational Expectations
B a c k g r o u n d to O u r In vo lvem en t at the F ederal Reserve B a n k o f M in n e a p o li s
While " ratio n al e x p e c t a t io n s " had appeared as a t e c h ­
nical t e rm in eco n o m ics lite ratu re as early as 1 9 6 1 , the
rational e x p e c tatio n s challe nge to activist m a c ro e c o ­
nomic policy t h e o ry is m u ch m ore re ce n t. And a key ele­
m e n t o f the challenge was developed at the Federal
R e s e r v e B a n k of Minneapolis.
T h e Ba nk had, in 1 9 7 0 , launched a ma j or research
pr ogr am expl ori ng h o w best t he Federal O p e n Ma r k e t
C o m m i t t e e ( F O M C ) should make m o n e t a r y policy. In
1 9 7 0 and 1 9 7 1 , respectively, Neil Wallace and T h o m a s
S a r ge nt , pr of e s sor s of ec o n o mi c s at t he Uni versi t y of
Mi nne s ot a , joined t he Bank' s re s e a rch d e p a r t me n t as
economi c advisors to assist in t hat program. Whi l e the
pr ogr am was unde r way, a seminal resul t appeared in a
1 9 7 2 paper by e c o no mi s t R o b e r t E. Lucas. Lucas, t he n at
Ca r ne gi e Mel l on Uni versi t y, had developed a rational
e xpe c t at i ons model of t he bus i ness cycle. T h e theoret i cal
i mpor t a nce of his wo r k can hardly be overst at ed: f or the
first time, busi ness cycles could be explained using a
model c on s i s t e n t wi t h t he core of s t andard economi c
theory.
Rat i onal e xpe c t a t i ons was quickly seen by S a r g e n t and
Wallace to be of gr e at i mpo r t anc e to t he r es earch
pr o g r am being carried on at t he Federal R e s e r v e Bank of
Minneapol is, particularly as t he y began to flesh out the
policy i mplications of Lucas' model. T h e y found t hat
rational e xpe c t a t i o ns could deprive activist ma c r o e c o ­
no mi c pol icy o f a n y s y s t e m a t i c real e f f e c t s . T h e i r
findings me a n t that activist mo n e t a r y policy by the
Federal R e s e r v e — t i ght e ni ng t he mo n e y supply to cool
an over he at e d e c o n o my or expandi ng t he m o n e y supply
to s t imul at e a lagging e c o n o m y — mi ght not wo r k in the




way it had long been believed to be ef f ect i ve. S ub s e q ue nt
research by S a r g e n t and Wallace has established t hem,
with Lucas, as the leading t heori st s of the new view.
T o ext e nd discussi on of t he rati onal expect at ions
view, t he Ba nk has sponsor ed a n u m b e r of c onf erenc es
and semi nars, publishing papers and proceedings f rom
t hose c o n f e r e n c e s and semi nars. In 1 9 7 4 , the Bank
sponsored a c o n f e r e n c e on the rati onal expect at ions
chal lenge to c u r r e n t pol icy- maki ng procedures, inviting
several of t he leading schol ars on b ot h sides of the
e me r g i n g debate. In J une of 1 9 7 5 we published S a r ge nt
and Wallace's paper, Rational Expectations and the Theory of
Economic Policy, f ro m t he 1 9 7 4 c o n f e r e n c e as the second
edition in o ur St udi es in M o n e t a r y Economi cs ( SME)
Series. T h e third publication in our S M E Series, Rational
Expectations and Theory of Economic Policy: Arguments and
Evidence by S a r g e n t and Wallace, c ame o ut of a series of
s emi nars on F O M C pol icymaki ng conduct ed in 1 9 7 5 by
t he Bank' s re s e arch staff. F u r t he r wo r k by various
res earch st af f m e m b e r s o n t he rational expect at ions
chal lenge was published in 1 9 7 6 as A Prescription for
Monetary Policy. In 1 9 7 7 , t he B a n k published proceedings
of a 1 9 7 5 c o n f e r e n c e on busi ness cycle research, New
Methods in Business Cycle Research, t hat related to our
rational e xpe c t a t i ons work.
T h e Bank is c ont i nui ng its p r o g r a m of f undament al
studies of r e q u i r e me n t s f or opti mal mo n e t a r y policy,
wi th c ur r e n t emphasi s o n clari fying t he f oundat i ons of
mo n e y in rational e xpe c t at i o ns models. A c onf e r e nc e of
leading schol ars dealing wi t h t hat topic has been planned
for t he fall of 19 7 8 .

3

p a r t i c u l a r a t l e a s t r e a s o n a b l e a c u m e n w h e n it c o m e s t o
making c o m m it m e n t s affecting their personal economic
i n t e r e s t s . T h a t m u c h is g r a n t e d t o o t h e r a c t o r s in t h e
s t o r y , o f c o u r s e . O u r c o n c l u s i o n t h e n is t h a t t h e a c t i v i s t
pol i c y p r o c e s s w e ' v e b e e n d e s c r i b i n g wi ll n o t b r i n g a b o u t
a n y o v e r a l l r e a l e x p a n s i o n in t h e p r i v a t e e c o n o m y —
unless it catches people by surprise.
Some indications o f la b o r m arket response to prospective
inflation. O n e o f t h e a r g u m e n t s s u p p o r t e r s o f a c t i v i s t
c o u n te rc y c lic a l policy m a k e a g a in s t the ra tio n a l
expectations view starts with the o bservation that labor
f r e q u e n t ly locks itself i nt o c o n t r a c t s by fixing t he c o u r s e
o f w a g e s f o r a s m u c h as t h r e e y e a r s i n t o t h e f u t u r e . T h a t
f ac t , pl us p e r h a p s s o m e s l o w n e s s o n t h e p a r t o f w o r k e r s
i n r e c o g n i z i n g w h a t ' s h a p p e n i n g t o p r i c e s in g e n e r a l ,
m e a n s t h e r e ' s a b u i l t - i n d e l a y in w a g e a d j u s t m e n t s . B u t ,
so the s tor y goe s, pr oduc t prices c an re s p o n d quickly to a
policy s t im u lu s , and t h e r e f o r e t e m p o r a r y p ro fit
opp o rtu ni tie s, at least, can be c re a t ed by policy action.
T h a t p r o v i d e s i n c e n t i v e f o r b u s i n e s s t o e x p a n d , if o n l y
t e m p o r a r i l y , a n d t h u s s o m e p o t e n c y is r e t a i n e d b y
a c t i v i s t pol i c y.
T h a t f r a g i l e l o o p h o l e c a n n o t b e r e l i e d o n in t h e
p u rsu it o f a n y s y s t e m a t ic c o u n t e r c y c li c a l policy.
C o n t r a c t s ar e periodically r e w r i t t e n and can c er ta in ly
take into a c c o u n t an y earlier m isre ading of g o v e r n m e n t
policy s t r a t e g y on t h e p ra c ti c a l p r in c ip le o f " o n c e
bur ned , tw ice c a u t i o u s . " O n e possible r e s p o n s e by labor
to b e i n g c a u g h t s h o r t in m i d c o n t r a c t b e c a u s e o f
u n p r e d i c t a b l e p o l i c y m o v e s b y g o v e r n m e n t is s i m p l y t o
s h o r t e n t h e c o n t r a c t period t h e n e x t time. T h a t c o u r s e
w a s p o i n t e d o u t in 1 9 7 1 b y U n i t e d A u t o W o r k e r s
P r e s i d e n t L e o n a r d W o o d c o c k w h e n h e s ai d,
. . if l a b o r
c o n t r a c t s c a n b e t o r n u p b a s e d u p o n t h e s t r o k e o f a p e n [a
reference to the W a ge-P rice Freeze on A u g u s t 1 5 ,1 9 7 1 ],
t h e n o b v io u sl y w e ca n no l o n g e r in t h e f u t u r e n e g o t i a t e
contracts for any longer than one yea r."
A n a l t e r n a t i v e r e s p o n s e b y l a b o r is t o s t a y w i t h
longer-term con tracts but base th e m on a better fo recast
o f i n f l a t i o n . In f a c t , t h e c l o s e r l a b o r c a n c o m e t o h a v i n g
w a g e s fu l l y a d j u s t e d f o r c h a n g e s in c o s t - o f - l i v i n g
i n d e x e s , t h e c l o s e r it c o m e s t o m a k i n g a " p e r f e c t "
forecast. T h a t situatio n, f r o m labor's poi nt of view,
w o u l d b e t h e u l t i m a t e in r a t i o n a l e x p e c t a t i o n s a n d w o u l d
obv ious ly f r u s t r a t e t h e K e y n e s i a n policy m e c h a n i s m
described earlier.
A telling i llu st rat io n of t h e w a y la bo r has m o v e d to
p r o t e c t its r e a l e a r n i n g s in t h e r e c e n t e n v i r o n m e n t o f
h i g h p r i c e i n f l a t i o n is t h e d a t a o n t h e p e r c e n t a g e o f
w o r k e r s c o v e r e d by c o s t - o f - l i v i n g c l a u s e s in t h e i r
c o n t r a c t s . W e ' v e p l o t t e d t h a t d a t a i n F i g u r e 1. I t s u g g e s t s
t h a t l a b o r is i n f a c t r e s p o n d i n g i n a " r a t i o n a l " w a y t o
g o v e r n m e n t ' s c o n t i n u i n g f a i l u r e t o d e l i v e r o n its
a n n o u n c e d policy goals f o r c o n t a i n m e n t o f inflation.

4



Figure 1. Percent of W orkers Under
C o n tra ct Covered by C o st-o f-L ivin g Escalation

High Inflation
Period
100

75

50

25

1960

1965

1970

1975

S ource: M o n th ly L ab or Review

Story two: countercyclical policy that takes effect
by w a y o f interest rate channels.
N o w let's l o ok at a n o t h e r c o m m o n l y hel d n o t i o n o f h o w
m onetary-fiscal stim ulus makes things move. This one
operates th ro u g h a d ifferent m arket, the m arket for
i n v e s t m e n t fu n ds , and s e e m s to dep end o n a kind of
s h o r t s i g h t e d n e s s by suppliers of f un ds re g ard ing th eir
prospective " re a l" interest earnings. T h e earningsv e r s u s - i n f l a t i o n d is c r e p a n c y t h a t policy app e ars to
e x p l o i t h e r e p a r a l l e l s l a b o r ' s " i l l u s i o n " a b o u t its w a g e in
t h e f i r s t s t o r y . A c c o r d i n g t o t h i s po l i c y s t o r y , p o l i c y
m a k e r s ' a c t i o n s t o e x p a n d t h e r a t e o f m o n e y g r o w t h will
influence business expansion decisions and c o n su m e r
s pend ing decisions t h r o u g h i n t e r e s t rates.
T h e s t o r y g o e s as f o l l o w s .
S t a r t w i t h t h e p e r c e p t i o n t h a t t h e e c o n o m y is in, o r
g oin g into, a rec ess ion . Policy a u t h o r it i e s act to exp an d
the m o n e y supply g r o w t h rate. T h e Federal R e s e r v e
d o e s t h i s by s t e p p i n g u p i t s b u y i n g o f s e c u r i t i e s f r o m t h e
p u b l i c ( t h r o u g h a n e t w o r k o f d e a l e r s in N e w Y o r k ) . B y
t h a t d eli be rat e a c tio n t h e public end s up w i t h a f l ow of
n e w ca sh, and b a n k s end up w i t h a f l ow o f n e w r e s e r v e s

t h a t e n a b l e t h e m t o e x p a n d l o a n s t o b u s i n e s s e s , if t h e y
c a n fi nd c u s t o m e r s , b y s e v e r a l t i m e s t h e a m o u n t o f t h e
new reserves.
O t h e r th in g s b ein g equal, th e b u y i n g ac tio n o f the
F e d d r i v e s s e c u r i t i e s prices up, a n d t h a t m e a n s i n t e r e s t
rates are driven dow n on th ose securities. T h e
s u b seq u e n t action by banks seekin g to m ake loans at a
f a s t e r pace t h a n t h e y w o ul d h a v e d o n e o t h e r w i s e , o r to
b u y b o n d s in g r e a t e r v o l u m e s t h a n t h e y w o u l d h a v e
d o n e o t h e r w i s e , h e l p s m o v e still o t h e r i n t e r e s t r a t e s
down.
In t h e n e x t step, b u s i n e s s f i r m s e x p a n d i n v e s t m e n t
in n e w p r o d u c t i o n facil iti es. O n e w a y t o i m a g i n e w h y
t h e y w o u l d d o s o is t o c o n s i d e r i n t e r e s t o n b o r r o w e d
b u s i n e s s f u n d s as s i m p l y a n o t h e r c o s t o f d o i n g b u s i n e s s ,
j u s t as w a g e s fo r labo r inpu ts a re a c os t o f doing
business. As expectations adjust to the prospect of lower
in te re st costs, som e in v e s tm e n t possibilities not
p r e v i o u s l y v i e w e d a s p r o f i t a b l e wi ll s u d d e n l y a p p e a r
p ro fita b le — exp ected re v e n u e s don't c h a n g e, but
expected costs go dow n because the in terest cost
c o m p o n e n t has gone down. T h u s, plant and e q uipm en t
i n v e s t m e n t s ar e u n d e r t a k e n , n e w w o r k e r s a re hired,
a n d n e w o u t p u t is p r o d u c e d .
T h e l a s t s t e p in t h e s t o r y s i m p l y r e c o g n i z e s t h a t t h e
added n e w w o r k e r s s t a r t s o m e n e w s p e nd in g o f th e ir
o w n , w h i c h f u r t h e r raises d e m a n d , c a u s in g additional
b u s i n e s s e s to e x p a n d t h e i r o u t p u t , and so on. T h u s ,
n a t i o n a l p r o d u c t e x p a n d s b y s o m e m u l t i p l e o f t h e i ni t i a l
i n v e s t m e n t s t i m u l u s , a n d w e ' v e s u c c e e d e d in b r i n g i n g
a b o u t large real e f f e c t s o n t h e e c o n o m y t h r o u g h small
c h a n g e s in m o n e t a r y pol i c y.
O n c e this p ro c e ss ge ts u n d e r w a y (plant e x p a n s i o n ,
n e w h i r i n g , a n d all t h a t ) , t h e i n c r e a s e d p r i v a t e s p e n d i n g
w o u l d , j u s t a s in t h e f i r s t s t o r y , l i k e l y b r i n g f o r t h s o m e
m i x t u r e o f p r i c e i n c r e a s e s a n d r e a l q u a n t i t y i n c r e a s e s in
the flow of goods and services. T h is story seem s even to
a l l o w w a g e r a t e s t o b e bi d u p a p p r o x i m a t e l y in l in e w i t h
prices as e x p a n s i o n m o v e s along. T h e p r o s p e c t o f w a g e
rat e in c re a s e s can be a pa rt of b u s i n e s s f i r m s ' e x p e c t a ­
t i o n s — as l o n g as t h e n e c e s s a r y c ap it a l f u n d s h a v e b e e n
or can be a c q u ire d t h r o u g h b o r r o w i n g at b a rg a in
i n t e re s t rates.
Inte re st rate responses to m o n etary-fiscal actions
a p p e a r t o b e t h e c r u c i a l l i n k in t h e s t o r y w e ' v e j u s t t old.
Interest rate responses also seem to provide the main
c h a n n e l t h r o u g h w h i c h m o n e t a r y policy a c t io n s a f f e c t
e m p l o y m e n t and o u t p u t in t h e large m a c r o e c o n o m e t r i c
mo de ls o f t h e U n i ted S t a t e s e c o n o m y c u r r e n t l y us ed by
g o v e r n m e n t t o a s s i s t i n d e t e r m i n i n g p o l i c i es a n d b y
b u s i n e s s t o a s s i s t in d e t e r m i n i n g i t s s t r a t e g i e s . T h e l a r g e
m u l t i - e q u a t i o n " M P S " mod el dev el ope d by t h e Fed era l
R eserve, M a ssa ch u se tts In stitu te of T ech n o lo g y,
U niversity of Pennsylvania, and the Social S ciences
R e s e a r c h C o u n c i l ha s five directly de fi ne d c h a n n e l s t h a t




depend on in terest rate m o v em en ts. So m e dozen
d i f f e r e n t i n t e r e s t r a t e s a p p e a r in t h e e q u a t i o n s t o h e l p
g e n e ra te q u a r t e r - b y - q u a r t e r pred ictions of total
s p e n d i n g f o r s u c h c a t e g o r i e s as c o n s u m e r d u r a b l e s ,
a u to m o b ile s, p ro d u c e rs ' d u rab le eq u ip m en t, and
res idential c o n s t r u c ti o n . T h e i n t e r e s t ra te linkage s ee m s
also to be a ke y pa rt of t h e l o os er and m o r e ge ner ali zed
a n e c d o t a l s t o r y t h a t y o u m i g h t g e t if y o u a s k e d s o m e
policy m a k e r s h o w th e i r deci sion s a f f e c t the e c o n o m y .
In t h e r a t i o n a l e x p e c t a t i o n s v i e w , h o w e v e r , t h o s e
stories are w ro n g. T h e inte re st-ra te -link story doesn't
take a broad e n o u g h perspective and doesn't adequately
a c co m m o d a te the way people rationally form their
e x p e c t a t i o n s . W h i l e it' s u n d e n i a b l e t h a t F e d e r a l R e s e r v e
action to buy securities and expand bank reserves results
i n b i d d i n g i n t e r e s t r a t e s d o w n , t h a t r e s p o n s e is
t e m p o r a r y a n d f l e e t i n g . T h e p o i n t is t h a t r a t i o n a l
lend ers and in v e sto rs , w h o look ahe ad to later ch a pte rs
o f th e s to ry , see t h a t an y Fe d e ra l R e s e r v e push to e xp an d
m o n e y g r o w t h r a t e s wi l l u l t i m a t e l y r a i s e t h e g r o w t h in
t h e g e n e r a l p r i c e l evel . F o r e s e e i n g t h a t o u t c o m e , l e n d e r s
w o n ' t w a n t t o t i e u p f u n d s in l o n g - t e r m l o a n s a t r a t e s o f
i n t e r e s t w h i c h t h e y had calculated to be ac ceptable
u n d e r an o u t d a t e d v ie w o f f u t u r e inflation. If th e y w e r e
to c o m m it their funds w ith no upw ard adjustm ent of
th e i r le ndi ng rate , t h e y w o u l d be a g r e e i n g to accep t a
l o w e r r a t e o f r e t u r n in t e r m s o f t h e g o o d s a n d s e r v i c e s
t h e y w o u l d s u b s e q u e n t l y b e a b l e t o b u y . A n d n o t h i n g in
t he o u t l o o k has c h a n g e d t h a t should lead t h e m to w a n t
to do that.
I n s t e a d , t h e y w o u l d add a n " i n f l a t i o n p r e m i u m " to
t h e i n t e r e s t r a t e s t h e y a r e wi ll i ng t o s e t t l e f o r — a little
i n s u r a n c e policy a g a i n s t t h e h e i g h t e n e d pr o sp ect s for
i n f l a t i o n . A n d i n t e r e s t r a t e l e v e l s f i n a l l y s e t t l e d o n in t h e
financial m a r k e t s ha v e g o t to re flect th a t p r e m iu m .
Fi na l l y , if t h e l o n g - t e r m i n t e r e s t r a t e s r e l e v a n t f o r
b u s i n e s s c a p i t a l e x p a n s i o n g o u p b y t h e f ul l a m o u n t o f
e x p e c t e d i n f l a t i o n , as t h e r a t i o n a l i s t s a r g u e w o u l d o c c u r
w i t h a n y f o r e s e e n i n f l a t i o n , all c o s t s — i n c l u d i n g
i n t e r e s t a s a c o s t — wi l l g o u p p r o p o r t i o n a t e l y t o t h e
e x p e c t e d p r i c e r i s e s o t h a t n o t h i n g wi l l h a v e c h a n g e d in
t e r m s o f e xp lo it ab le p ro fi t o p p o r t u n i t ie s . In s h o rt , w h e n
p o l i c y m o v e s a r e a n t i c i p a t e d o r q u i c k l y s e n s e d in m a r k e t
s i g n a l s , t h i s f i n a n c i a l m a r k e t c h a n n e l t o po l i c y r e s u l t s
we've been describing w o n 't w o rk either.
S o what's the evidence tha t interest rates don't behave
as t h e c o n v e n t i o n a l pol ic y v i e w w o u l d a r g u e t h e y
sh oul d? A n y simple lo ok at the r e la tio n sh ip b e t w e e n
m o n e y g r o w t h a n d i n t e r e s t r a t e l e v e l s in t h e h i s t o r i c a l
r e c o r d is b o u n d t o i g n o r e a l ot o f o t h e r f a c t o r s a l so
i n fl u e n c in g h o w t h o s e t w o th i n g s b eha ve. Y e t th e fact
th a t e c o n o m i c data ju st d on't s h o w hi gh rates of m o n e y
g r o w t h r e g u l a r l y a s s o c i a t e d w i t h l o w level s o f i n t e r e s t
r a t e s m u s t , at t h e v e r y l e a st , r a i se d o u b t s a b o u t t h e
d e p e n d a b i l i t y o f t h a t p e r c e i v e d r o u t e f o r po l i c y a c t i o n s .

5

Figure 2a. Interest Rate vs.
M oney G row th fo r O EC D C ountries

Figure 2b. Interest Rate vs. M oney G row th
Q u a rte rly average U.S. d ata 1954 th ro u g h 1977

Nov. 1976 s h o rt te rm in te re s t rates vs. rate o f m o ne y
g ro w th Nov. 1976 over Nov. 1975
S h o rt-te rm
Interest
Rates

C o rp o ra te
A A A B ond
Rate
10

20

18

• 1 Lilly

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16

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14

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6

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^ •G e rm a n y
S w itzerland

4

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0

2

4

6

8

10

12

14

16

18

20

22

24

M oney s u p p ly g ro w th % ch an g e over yr. ago

-4

-2

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:

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10

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6

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12

M oney s u p p ly (M ,) g ro w th ann ual rate

Source: Federal Reserve Bank of New York

Y o u c a n l o o k a t e x p e r i e n c e a c r o s s c o u n t r i e s [ F i g u r e 2a]
o r o v er a period of ti m e w ithin th e U nited S t a t e s [Figure
2 b] a n d s e e t h a t h ig h e r i n t e r e s t r a t e s , n o t l o w e r , a p p e a r , if
anything, to go along with higher rates of m o n e y e x p a n ­
sion — pro bab ly r e fle ctin g h i g h e r actual and e xpe c te d
inflation rates.
T o s u m up, t h e r a t i o n a l e x p e c t a t i o n s v i e w a r g u e s
th at c o n v e n tio n a lly p erceiv ed policy c h a n n e ls —
w h e th e r operating th ro u g h w age costs, interest costs,
or any o th e r m arket-respo nsib le variable — are w ro n g
because they depend on having people behave c o n tra ry
to thei r o w n clear b e st i n t e r e s t s , re p e at e d ly ne g le c t in g
im portant info rm atio n they have or can have about any
s y s t e m a t i c a l l y a p p l i e d pol i c y.

II. How valid is rational expectations
as a representation of people’s behavior?
S o m e critics a r g u e t h a t ra ti ona l e x p e c t a t i o n s d e m a n d s
t oo m u c h w i s d o m and p e r c e p t i v e n e s s o f peo ple to be
believable. B u t t h e validity o f ra ti o na l e x p e c t a t i o n s does
n o t r e q u i r e t h a t every c o n s u m e r o r w o r k e r o r b u s i n e s s
m a n a g e r be t he " c o m p l e t e s e e r " o f f u t u r e prices and
o t h e r e c o n o m i c e v e n t s . F o r e x a m p l e , in t h e c a s e o f w a g e
b ar g ai n in g by o rg a n i z e d labor, o n l y t h e u n io n le ad ers hi p
a c t u a l l y e n g a g e d in t h e b a r g a i n i n g p r o c e s s — n o t e a c h

6



and e v e r y ra n k - a n d - f il e m e m b e r — need h a v e an
i n f o r m e d v i e w a b o u t w h a t g o v e r n m e n t p o l i c y is a n d
w h a t its c o n s e q u e n c e s f o r f u t u r e p r i c e l e v e l s a r e l i k e l y t o
be. T o d a y ' s u n i o n l e a d e r s h i p , a s w e p o i n t e d o u t in o u r
r e v i e w o f p o l i c y c h a n n e l s in t h e p r e v i o u s s e c t i o n , d o e s ,
in fact, a c k n o w l e d g e its c o n c e r n a b o u t p ro s p e ct i v e " r e a l "
earnings. Small agricultural enterprises or c om m o d ity
d ealers need n o t ha v e specialized r e s o u r c e s of t h e i r o w n
to fo re c a st supply and d e m a n d m o v e m e n t s and th e
e f f e c t s o f g o v e r n m e n t p o l i c i e s . All t h e y n e e d d o t o l e a r n
w h a t t h e e x p e r t s a r e e x p e c t i n g in f u t u r e m a r k e t
s i t u a t i o n s is pi ck u p t h e n e w s p a p e r , o r t h e p h o n e , a n d
c h e c k on q u o t e d f u t u r e s prices — o r s u b s cr i b e at m o d e s t
price to o n e o f m a n y pr iv at e n e w s l e t t e r s . In t h e ca se of
small b o r r o w e r s and in v e sto rs , th e in fo rm a tio n
p o sse sse d by large and s op hi st ic a t e d b o r r o w e r s and
suppliers of funds b e co m e s very quickly and widely
r e f l e c t e d in p u b l i c i z e d i n t e r e s t r a t e s . S t u d i e s h a v e
s h o w n th at financial m arkets, including the stock
m a r k e t s , a r e e f f i c i e n t u s e r s o f i n f o r m a t i o n in t h e s e n s e
t h a t prices qu ickly a dju s t to re fl ect e x p e r t i n f o r m a t i o n
o n all t h e f a c t o r s — g o v e r n m e n t p o l i c y i n c l u d e d —
b e a ri ng on f u t u r e profitability.
Clearly the m a jor industrial and com m ercial firms
in t h e e c o n o m y h a v e a c r u c i a l f i n a n c i a l s t a k e in c o r r e c t l y

f o r e c a s t i n g h o w t h e y wi l l b e a f f e c t e d b y c h a n g e s in
g o v e r n m e n t po l i c y. A n y a c t i o n s t h e y t a k e , b e c a u s e o f
c h a n g e d e x p e c t a t i o n s , in p r o d u c t o r r e s o u r c e m a r k e t s
will q u i c k l y c a r r y t h e m e s s a g e o f t h e i r r e a p p r a i s a l t o
o t h e r partic ipan ts, large and small, on b o t h sides of th e
market.
Finally, w h e n w a g e ra t e s o f a p a rti c ul a r fi rm ge t o u t
o f l in e w i t h o t h e r f i r m s c o m p e t i n g f o r t h e s a m e l a b o r
p o o l , r e a c t i o n b y o n l y a f e w w o r k e r s is n e c e s s a r y , in
g e n e r a l , in o r d e r t o c a u s e t h e f i r m t o a d j u s t i t s w a g e
rates to the prevailing m arket. P erhaps none of the
w o r k e r s n e e d t a k e d i r e c t a c t i o n if t h e f i r m m o n i t o r s t h e
m a r k e t a n d a d j u s t s its s a l a r y s t r u c t u r e , as m a n y f i r m s
do, u s i n g p r o j e c t i o n s b a s e d o n m a r k e t s u r v e y s . S u c h
s u r v e y s wi ll r e f l e c t w h a t ' s h a p p e n i n g a t t h e m o r e
responsive firms, including the effects of escalator
p ro v i si o n s and o t h e r u n io n b a r g a in in g resul ts. In s u m ,
t h e r a t i o n a l e x p e c t a t i o n s a r g u m e n t is t h a t i n f o r m a t i o n
a b o u t t h e l i k e l y f u t u r e is t r a n s m i t t e d in t h e m a r k e t p l a c e
in t h e s a m e w a y a s i n f o r m a t i o n a b o u t t h e p r e s e n t . A
g i v e n i n d i v i du a l o r f i r m n e e d n o t b e t h e " c o m p l e t e s e e r "
of the fu tu re any m o re than of the present.

S o m e evidence f r o m econom ic d ata.
T h e rational expectations view argues that existing
econ om ic models and theories that have dominated
a c t i v i s t p o l i c y t h i n k i n g f o r y e a r s fai l t o p r o p e r l y c a p t u r e
the true responsiveness of real-life decision m akers to
g o v e r n m e n t p o l i c y a c t i o n s . If t h a t ' s t r u e , t h e n t h e
f o r e c a s t s g e n e r a t e d by s uch m od e ls o u g h t to b e t r a y th a t
d e f e c t d u r i n g a p e r i o d in w h i c h p o l i c y a b r u p t l y c h a n g e s .
A lth ou gh traditional models have not been subject to
this t e s t directly, t h e y ha v e b e e n fo u n d to be u n s t a b l e
outside the sample period o v er which they w e re esti­
m a t e d [4].
T h e f a c t t h a t s t a n d a r d m o d e l s fail i n t h i s w a y
s u g g e s t s t h a t s o m e t h i n g is s e r i o u s l y w r o n g w i t h t h e m .
I n p a r t i c u l a r , t h a t " s o m e t h i n g " m a y w e l l b e t h e w a y in
w h i c h t h e e c o n o m i c a c t o r s are r e p r e s e n t e d as f o r m i n g
t h e e x p e c t a t i o n s o n w h i c h e c o n o m i c d e c i s i o n m a k i n g is
based. T r a d i t i o n a l mo d e ls s e e m to limit t o o rigidly t he
c a p a c i t y g r a n t e d t o t h e i r i mp l i c i t d e c i s i o n m a k e r s t o
judge and react to n e w inform ation.
B u t w h a t does t h e test of r e c e n t h i s to r y h a v e to say
a b o u t h o w well ra t i o n a l e x p e c t a t i o n s p e r f o r m s as a
mo d el o f people's real-life decision p ro c e ss fo r t he
e c o n o m y as a w h o l e ? T h e t e c h n i c a l d e f i n i t i o n o f r a t i o n a l
e x p e c t a t i o n s ca n be vie we d as a v e r y strict a s s u m p t i o n —
" e x t r e m e , " as s o m e critics c o n t e n d — a b o u t the
k n o w l e d g e and p e r c e p t i v e n e s s people h a v e re g a rd i n g
w h a t ' s h a p p e n in g in th e e c o n o m y . Y e t , in a n o t h e r study,
T h o m a s S a r g e n t [6] h a s s h o w n t h a t a r a t i o n a l e x p e c t a ­
tions version of a m a c ro e c o n o m ic model, even th o u g h
built u p o n e x t r e m e a s s u m p t i o n s a b o u t t h e w a y people
s e e t h r o u g h p o l i c y a c t i o n s , w a s n o t a t all i n c o n s i s t e n t
w i t h data f r o m t h e U n i t e d S t a t e s e c o n o m y . T h e data




used ref lected, o f c o u r s e , e x p e c t a t i o n s people act ually
held and d ec isio n s p eo p le a c tu a lly m ad e. F r o m a
scientific po in t o f vie w , pa s si n g s u c h a te st d o e s n 't p r o v e
t h a t t h e r a t i o n a l e x p e c t a t i o n s v i e w is t h e c o r r e c t o n e .
T h e strict f o r m o f ra t i o n a l e x p e c t a t i o n s mo d el used by
S a r g e n t m e r e l y s u r v i v e s a s o n e l e g i t i m a t e c a n d i d a t e in a
c o n t e s t th at m a y n e v e r be fully decided f r o m t h e
h i s t o r i c a l d a t a.
B u t o t h e r n e w r e s e a r c h has e x t e n d e d in a b r o a d e r
f r a m e w o r k th e basic ra t i o n al e x p e c t a t i o n s i n s ig h t s i nt o
e c o n o m i c po l i c y m a k i n g a n d t h e p o l i c y - n e u t r a l i z i n g
ef f e c t of people's e c o n o m i c d e c i s i o n - m a k i n g b e h av i o r .

Support fr o m developm en ts in theory:
the new view an d the P h illip s curve.
Significant support for the credibility of rational
expectations com es fro m new w o rk incorporating
r a t i o n a l individual a g e n t s i n t o a m o r e b r o a d l y i n t e g r a t e d
eco n o m ic model th a t e xh ib its b u sin e ss cycles and
explains t he so-called Phillips c u rv e . N o p re v i o u s t h e o r y
in e c o n o m i c s h a s m a n a g e d t o p e r f o r m t h a t j o b s a t i s ­
f a c t o r i l y . S i n c e t h e P h i l l i p s c u r v e is p a r t o f a c t i v i s t p o l i c y
lore, we w a n t to b ri ef ly s k e t c h w h a t t h e n e w v ie w has to
s a y a b o u t it.
In t h e l o n g h i s t o r i c a l r e c o r d , h i g h r a t e s o f i n f l a t i o n
have tended to go w ith high rates of e m p lo y m e n t, and
low rates of inflation have tended to go w ith low rates of
e m p l o y m e n t . T h a t k i n d o f r e l a t i o n s h i p is o f t e n r e f e r r e d
t o as a P hi l l i ps c u r v e a f t e r e c o n o m i s t A. W . P h i l l i p s , w h o
in 1 9 5 8 f i rs t d e s c r i b e d a c o n n e c t i o n b e t w e e n u n e m p l o y ­
m e n t r a t e s a nd w a g e - i n f l a t i o n r a t e s in B r i t i s h d a t a .
T o m a n y policy a c tiv is ts t h e Phillips r e l a t io n s h i p
offers som e hard empirical data tracing o u t various
com binations of labor m a r k e t conditions and inflation
pressures that corresp on d to and support the K e y n e s ian
pol i c y s t o r i e s w e ' v e d i s c u s s e d . I n a f a m o u s 1 9 6 0 a r t i c l e ,
e c o n o m i s t s P a u l S a m u e l s o n a n d R o b e r t S o l o w [5]
d e s c r i be d t h e o b s e r v e d r e l a t i o n s h i p in t h e U n i t e d S t a t e s
d a t a as a " m e n u o f c h o i c e " a v a i l a b l e t o t h e p o l i c y m a k e r .
Until re ce n tly th e Phillips cu rv e has b een w idely
a c ce p t e d a n d d e f e n d e d as a p r a c t i c a l m e a s u r e o f t h e
"tra d e -o ff" b e tw e e n national e m p l o y m e n t objectives
and inflation ob je ct iv e s.
B u t t h e P hi l l i p s c u r v e r e l a t i o n s h i p is n o l o n g e r
r e g a r d e d as a s t a b l e o r d e p e n d a b l e o n e . If a r e g u l a r t r a d e ­
o f f c a n e v e n b e d e c i p h e r e d in r e c e n t u n e m p l o y m e n t i n f l a ti o n dat a, t h e i n f l a t i o n " p r i c e " f o r b u y i n g l o w e r
u n e m p l o y m e n t a ppe a rs to h a v e g o n e up s ubsta ntially:
h i g h u n e m p l o y m e n t r a t e s n o w g o h a n d in h a n d w i t h
high inflation rates. P r o p o n e n t s o f " r a t io n a l e x p e c t a ­
tions" interpret the broad pattern o f these results — the
h i s t o r i c a l Phi l l i ps r e l a t i o n s h i p ( s u c h as it h a s b e e n ) a n d
t h e r e c e n t d e t e r i o r a t i o n o f t h e s u p p o s e d t r a d e - o f f — as
e v i d e n c e s u p p o r t i n g a m o d e l o f t h e e c o n o m y in w h i c h
rational e x p e c t a t io n s o p e r a t e s .

7

T h e n e w t h e o r y b ein g built arou n d ration al
e x p e c t a t i o n s a n d s o m e r e l a t e d i de a s d o e s in f a c t a c c o u n t
f o r hi storical Phillips c u r v e - li k e rel ationships. And t h o s e
r e l a t i o n s h i p s , a s p o i n t e d o u t b y R o b e r t L u c a s [3], t u r n
o u t s i m p l y t o b e t h e o b s e r v e d f a c t s o f t h e b u s i n e s s c yc l e .
T h e g e n e r a l pr i ce level , o u t p u t , a nd e m p l o y m e n t t end t o
m o v e up t o g e t h e r as pe ople re sp o nd to a r a t h e r ge n er a l
m i s r e a d i n g o f u n a n t i c i p a t e d p r i c e a nd d e m a n d c h a n g e s .
In t h e i n h e r e n t l y u n c e r t a i n e n v i r o n m e n t in w h i c h
d e c i s i o n s a r e m a d e , p e o p l e a t f i r s t t a k e t h e s e as s i g n a l s o f
expanded profit opportunities. S ubsequently, the same
three quantities tend to move down to g e th e r when
e x p a n s i o n is d i s c o v e r e d t o h a v e o v e r s t r e t c h e d t h e r e a l
l e v e l o f e c o n o m i c d e m a n d . But even though these economic
variables do move together in a m ore or less regular w a y — hence the
Phillips curve in the historical data — the rational expectations view
says this relationship cannot he re gularly exploited fo r government

Figure 3.
G eneralized E m p lo ym e n t-ln fla tio n U psw ing
fo r U.S. since m id-sixties
(P lo tte d p o in ts a re se m ia n n u a l averages)

Inflation Rate
(CPI, percent per year)

1971-73

1975-77

p o licy p u rp o ses. F o r if g o v e r n m e n t t r i e s t o r a i s e
e m p l o y m e n t ra te s by addi ng to a g g r e g a t e d em an d and
e x p a n d i n g t h e f l o w o f m o n e y , p e o p l e wi l l q u i c k l y
incorporate into their expectations the fact that a m ore
r a p i d l y r i s i n g l ev e l o f p r i c e s a n d w a g e s will s u r e l y f o l l o w .
B u s i n e s s f i r m s wi l l n o t t h e n b e l i ke l y t o m i s t a k e t h e p r i c e
a n d d e m a n d p r e s s u r e s t h a t s o o n o c c u r as s i g n a l s o f
p r o f i t o p p o r t u n i t i e s (a la t h e c h a n n e l s d e s c r i b e d e a r l i e r )
b e c k o n i n g t h e m to e x p a n d o u t p u t and e m p l o y m e n t .
A l t h o u g h a c t u a l d a t a f r o m t h e e c o n o m y is v e r y
" n o i s y " — m e a n i n g it j u m p s a r o u n d a l ot f r o m o n e
m o n t h o r q u a r t e r t o a n o t h e r in w a y s t h a t s e e m t o d e f y
e x p l a n a t i o n — it's p o s s i b l e t o s e e t h a t l o n g e r - t e r m
m o v e m e n t s in i n f l a t i o n r a t e s a n d e m p l o y m e n t r a t e s d o
c o n f o r m in a l o o s e w a y . D a t a in F i g u r e 3, t a k e n f r o m t h e
period 1 9 6 5 to 1 9 7 7 , s h o w t h r e e m a j o r up wa rd swings,
each o f severa l q u a r t e r s , tha t, loosely speaking, trace a
ki nd o f Phi ll ips c u r v e e x p a n s i o n a r y r e l a t io n s hi p . T h e
chart also indicates the deteriorating nature of that
relationship. Each successive upswing seem s on average
to require high er rates o f general inflation to "recap­
t u r e " t h e s a m e l e ve l o f t h e e m p l o y m e n t r a t e as o b s e r v e d
in t h e p r e v i o u s s w i n g . T h a t , a c c o r d i n g t o t h e r a t i o n a l ­
ists, m a y be e v id e n c e t h a t people ha v e inc or po ra te d into
t h e i r e x p e c t a t i o n s t h e g o v e r n m e n t ' s i n f l a t i o n a r y bi as o f
the past decade or longer.

III. What happens to activist macro policy
in a rational expectations world?
In e a r l i e r s e c t i o n s w e r e v i e w e d a r g u m e n t s f o r d i s b e l i e v ­
ing th a t m a c r o policy a c tio n s can w o rk the w ay
c o n v e n t i o n a l p e r c e p t i o n s s a y t h e y do, a n d w e p r e s e n t e d
r e a s o n s f o r t h i n k i n g t h a t t h e k i n d o f w o r l d pol i c y
m a k e r s m u s t d e a l w i t h is s o m e t h i n g v e r y c l o s e t o a
rational e xpectatio n s world.
T h e s e r i o u s p r o b l e m , t h e n , is t h e f o l l o w i n g : If
people really do b e h a v e as rati onal e x p e c t a t io n s models
t h e i r b e h a v i o r , t h e n m a n y e x i s t i n g b eli ef s a b o u t t h e


8


1965-69

56

57

58

Em ploym ent Ratio
(percent of total em ploym ent to non- in stitutio nal
pop ulation 16 and over)

r e s u lts policy can a c h ie v e a re i n c o r r e c t . As w e 'v e
a b u n d a n t l y s t r e s s e d already, m a c r o policy initiatives
t h a t p e o p l e a n t i c i p a t e wi l l b e f r u s t r a t e d b y t h e c h a n g e s
p e o p l e wi l l t h e n m a k e in t h e i r p l a n s . M o r e p a r t i c u l a r l y ,
a n y p o l i c y m o v e t o s t i m u l a t e a g g r e g a t e s p e n d i n g wi l l b e
l a r g e l y d i s s i p a t e d b y p r i c e r i se s .
W e wi ll g r a p h i c a l l y i l l u s t r a t e w h a t r a t i o n a l e x p e c t a ­
t i o n s d o e s t o c o n v e n t i o n a l m a c r o pol icy a c t i o n s t h r o u g h
s o m e c o m p a r a t i v e s im u l a tio n s pr od uc ed by a wellk n o w n , small e c o n o m e t r i c model.

A n illustration o f the effects o f r a tion a l
expectations on econom ic policy.
E co n o m e tric models are con structed of m ath em atical
e q u a t i o n s , o f t e n d e s i g n e d t o b e s o l v e d o n c o m p u t e r s in a
way capable of sim ulating the fu tu re course of an
econ om y. R esults can then be cranked out q u a r ter -b y qu a r te r to produce numerical forecasts of em p lo y m e n t,
p r i c e s , o r w h a t e v e r e c o n o m i c v a r i a b l e s a r e c o n t a i n e d in
t h e m o d e l . I t' s n o w a c o m m o n p l a c e t h a t m o d e l s o f t h i s

s o r t — s o m e w i t h as m a n y as s e v e r a l h u n d r e d e q u a t i o n s
— have since the m id -1 9 6 0 s b e co m e in cre a sin g ly
im p o rtan t in fo rm a tio n bases for business decision
m a k in g and fo r g o v e r n m e n t policy decision ma k in g.
C o n v e n t i o n a l p o l i c y t r a n s m i s s i o n c h a n n e l s , s u c h as
t h e w a g e i l l us i o n d e s c r i b e d in s e c t i o n I, a r e a l s o b u i l t i n t o
t r a d i t i o n a l e c o n o m e t r i c m o d e l s o f t e n u s e d as a bas is f o r
e v al u a t in g a l t e r n a t i v e policy actions. T h o s e mod els , o f
course, w e re not designed to reflect rational e x p e c ta ­
t i o n s , b u t t h e r e g e n e r a l l y is a w a y t o i m p o s e o n t h e m a
f o r m o f r a t i o n a l e x p e c t a t i o n s . W h en that's done, the revised
macro model reveals that activist economic policy does not have much
of an impact on the economic outcome — apart from what it does to
prices. W e ' l l i l l u s t r a t e t h a t i m p o r t a n t r e s u l t i n t h i s
section.

G etting a h a n d le on expectations.
Stru ctu ral eco n o m etric models are essentially compact
w a y s o f s u m m a r i z i n g a pa rti cu la r v ie w of the w a y people
b e h a v e . S o m e o f t h e e q u a t i o n s in a m o d e l will t h e r e f o r e
a t t e m p t to r e p r e s e n t t h e th in g s people take int o a c c o u n t
in m a k i n g d e c i s i o n s t o p r o d u c e , t o w o r k , o r t o b u y — a n d
t h a t m e a n s t h e i r expectations. I n t e r e s t r a t e s , f o r e x a m p l e ,
a r e p r e s u m a b l y a f a c t o r in b u s i n e s s d e c i s i o n s t o bui l d
n e w p ro d u c t i o n plants. S o an e q u a t i o n d esi gne d to
p r e d i c t h o w m u c h n e w p l a n t will b e b u i l t n e x t q u a r t e r o r
n e x t y e a r wi ll i n c l u d e v a r i a b l e s r e p r e s e n t i n g e x p e c t a ­
tions of bu siness m a n a g e r s and o t h e r s a b o u t f u t u r e
i n t e r e s t r a t e s as o n e o f t h e q u a n t i t i e s t h a t m u s t be fed
i n t o it.
F i n d i n g a m e a s u r e t o r e f l e c t p e o p l e ' s expectations i n a
m o d e l p o s e s a p r o b l e m . W e k n o w t h e m o d e l wi l l
e v e n t u a l l y g e n e r a t e its o w n r e s u l t s f o r t h e p a t h o f
f u t u r e v a l u e s o f its e c o n o m i c v a r i a b l e s — i n c l u d i n g , in
particular, those variables for which expectations need
to be form ed .
O n e v e r y simple w a y to p r o g r a m th e mode l to f o r m
e x p e c t a t i o n s f o r , s a y , f u t u r e i n t e r e s t r a t e s is t o h a v e t h e
m o d e l u s e its o w n m o s t r e c e n t q u a r t e r l y v a l u e as t h e
e x p e c t a t i o n f o r v a l u e s in all f u t u r e q u a r t e r s . A l e s s
s i m p l e a p p r o a c h is t o u s e s o m e a v e r a g e o f s e v e r a l r e c e n t
q u a r t e r s as a p r o x y e x p e c t a t i o n f o r f u t u r e i n t e r e s t r a te s .
T h a t's exactly w h at m o st c u rr e n tly used m odels,
i n c l u di n g t h e l a rg e m a c r o m o d e l s , do — s o m e t i m e s
e x p l i c i t l y b u t o f t e n i mpl i c i t l y . T h a t p r o c e d u r e is t e r m e d
"ad a p tiv e e x p e c ta tio n s " becau se of the way the
expectation slowly adjusts after an abrupt change occurs
in t h e l e v e l o f a c t u a l r a t e s b e i n g g e n e r a t e d .
O n e of the c o n se q u e n c e s of using adaptive
e x p e c t a t i o n s is t h a t v a l u e s p r o d u c e d f o r u s e a s t h e
model's expectations about each successive quarter's
in t e re s t ra te are usually n o t equal to th e i n t e re s t rates
e v e n t u a l l y p r o d u c e d b y t h e m o d e l w h e n it h a s b e e n r u n .
E c o n o m i s t J o h n M u t h had this d is cr e p an c y b e t w e e n
a d a p t i v e e x p e c t a t i o n s a n d m o d e l r e s u l t s in m i n d w h e n




h e u s e d t h e t e r m r a t i o n a l e x p e c t a t i o n s in 1 9 6 1 . H e c h o s e
t o s e t t h e e x p e c t a t i o n s v a l u e s f o r v a r i a b l e s n e e d e d as
i n p u t s t o v a r i o u s e q u a t i o n s s o a s t o b e e q u a l t o t h e f i na l
predictions eventually com ing out of the model. And,
from a technical standpoint, that's w h a t th e strict fo rm
of rational e x p e c t a t io n s m e a n s . Literally, t h a t defini tion
o f r a t i o n a l e x p e c t a t i o n s c r e d i t e d t h e m o d e l ' s i mp l i c i t
decision m a k e r s w i t h k n o w i n g as m u c h a b o u t t h e w a y
t h e e c o n o m y w o r k s a s is c a p t u r e d in t h e m o d e l i t s e l f a n d
w i t h h a v i n g f ul l c u r r e n t i n f o r m a t i o n a b o u t all o t h e r
e c o n o m i c v a r i a b l e s a s w e l l as s e t t i n g s o f t h e p o l i c y
i n s t r u m e n t s ( g o v e r n m e n t deficit, size o f t h e m o n e y
s t oc k , etc.) u n d e r pol ic y m a k e r s ' c o n t r o l . A s w e p o i n t e d
o u t in s e c t i o n II, t h a t m a y s e e m t o b e a s k i n g a l o t , b u t
subsequent ways of incorpo rating rational expectation s
in to m od els h a v e p r e s e r v e d th e e s s e n tia l policy
consequences of rational expecta tio n s while requiring
a g e n t s t o be less c o m p l e t e l y k n o w i n g a n d i n f o r m e d t h a n
outlin ed above.
N o w that we'v e described w h a t rational e x p e c ta ­
t i on s d o es t e c h n i c a l l y in e c o n o m i c m o d e l s , we' ll l o o k at
som e indicated re s u lts of policy th a t c o m e fro m
simulations of a version of the St. Louis Federal R e s e r v e
B a n k model — w i th and w i t h o u t ra ti ona l e x p e c t a t io n s .
In t h e d i a g r a m s [ F i g u r e s 4 a a n d 4 b ] w e s h o w w h a t
t h e o r i g i n a l m o d e l s a y s wi l l h a p p e n t o t h e u n e m p l o y ­
m e n t r a t e and t h e i n f l a t i o n r a t e as t w o a l t e r n a t i v e
choices fo r m o n e t a r y policy a re p u rs u e d . T h e period
s p a n n e d is f i r s t - q u a r t e r 1 9 6 0 t h r o u g h t h i r d - q u a r t e r
1 9 6 3 , a nd t h e c o m m o n s t a r t i n g o b s e r v a t i o n s ( u n e m ­
p l o y m e n t at 5 . 8 p e r c e n t a n d i n f l a t i o n at 2 p e r c e n t ) w e r e
approxim ate values for early 1 9 6 0 . T o obtain the
s e q u e n c e p l o t t e d in F i g u r e 4 a , w e i m p o s e d a 6 p e r c e n t
a n n u a l g r o w t h ra t e f o r m o n e y as an e x p a n s i o n a r y policy
m e a s u r e a n d l e t t h e m o d e l g e n e r a t e t h e t h i n g s it
determines internally, including the u n e m p l o y m e n t rate
and inflation rate. T h e m o d e l t h e n tra ce d o u t the
q u a r t e r - b y - q u a r t e r p a t h f o r t h e t w o v a r i a b l e s as s h o w n
in t h e d i a g r a m . T h a t p a t h is s u g g e s t i v e o f a s t a n d a r d
Phi l l i ps c u r v e p o l i c y " t r a d e - o f f " t h a t a s s o c i a t e s l o w e r
un em plo ym en t rates w ith high er rates of inflation.
T h e c u r v e in F i g u r e 4 b w a s s i m i l a r l y o b t a i n e d , t h e
o n l y d i f f e r e n c e b e i n g t h a t w e u s e d a l es s e x p a n s i o n a r y
m o n e t a r y policy a s s u m p t i o n by s e t t i n g t h e a n n u a l
m o n ey g ro w th rate at 4 percent.
A policy a c t i v i s t w h o a c c e p t e d t hi s s t a n d a r d v e r s i o n
o f t h e S t . L o u i s m o d e l as a g o o d r e p r e s e n t a t i o n o f t h e
e c o n o m y m i g h t feel e n c o u r a g e d at th e o u t s e t of th e
sim ul a tio n period t h a t t h e u n e m p l o y m e n t ra te could be
" e n g i n e e r e d " to a l o w e r level by p u r s u i n g e x p a n s i o n a r y
m o n e y g r o w t h . M o r e o v e r , th a t re sult a p p a r e n t ly could
b e a c h i e v e d f a i r l y q u i c k l y a t m i n i m a l c o s t in t e r m s o f
e x t r a inflation. W i t h a 6 p e r c e n t m o n e y g r o w t h ra te , f o r
ex a m pl e, we'd get t h e u n e m p l o y m e n t ra te d o w n v e r y
c lo s e t o 4 p e r c e n t in a b o u t f i ve q u a r t e r s , a n d t h a t w o u l d

9

Figure 4. P olicy Sim ulation Results using St. Louis Federal Reserve Bank Model

Infla tio n
Rate
(% /yr.)

b.
O riginal version
with 4% m oney grow th

a.
O rig in a l version
w ith 6% m oney g ro w th

c. Rational expectations version
w ith 6% m oney grow th

Inflation
Rate
(%/yr.)

Five qua rters
at 6%
m oney g ro w th rate

Five q u a rte rs
at 6% m o n e y g ro w th rate
w o u ld get us here

common
starting
point
1960:1

-#

3

4

5

U n e m p lo y m e n t Rate (p e rc e n t)

6

com m on

01 starting
point

Five q u a rte rs
at 4% m o ney g ro w th rate
w o u ld get us here

7

2

3

4

add o n l y a b o u t h a l f a p e r c e n t a g e p o i n t t o t h e i n f l a t i o n
rate. Using a 4 percent m o n e y g r o w th rate over the sam e
f i v e q u a r t e r s a s d e p i c t e d i n F i g u r e 4 b , w e w o u l d n o t do
q u i t e a s w e l l f o r t h e u n e m p l o y m e n t r a t e ( c u t t i n g it o n l y
t o t h e 5 p e r c e n t level ), b u t t h e i n f l a t i o n r a t e w o u l d e v e n
d e c l i n e a l i t t l e. T h u s t h e " m e n u o f c h o i c e " o p e n t o t h e
policy m a k e r w o u l d be a m e n u of al t er n at i v e paths
t h r o u g h t i m e f o r t h e e c o n o m y , a nd t w o o f t h e s e l e c t i o n s
a r e i l l u s t r a t e d in F i g u r e s 4 a a nd 4 b . A po l i c y m a k e r
c o n s i d e r i n g j u s t t h e s e t w o o p t i o n s m i g h t we l l d e c i de
t h a t it's b e t t e r t o t a k e t h e f a s t e r r o u t e t o w a r d a 4 p e r c e n t
u n e m p l o y m e n t o b j e c t i v e — g i v e n t h e s ma l l a d d i t i o n a l
i n f l a t i o n t h a t w o u l d b e c a u s e d . ( O f c o u r s e , t h e pol i c y
a u t h o r i t y m i g h t t h e n ne e d to be prep ar ed to shift g ea rs
to l o w e r m o n e y g r o w t h r a t e s as th e e c o n o m y nea red the
c h o s e n u n e m p l o y m e n t o b j e c t i v e in o r d e r t o a v o i d m u c h
h i g h e r i n fl a tio n r a t e s la t er on.)


10


5

U n e m p lo y m e n t Rate (percent)

6

3

4

5

U n e m p lo y m e n t Rate (percent)

U n f o r t u n a t e l y , in a w o r l d o f r a t i o n a l e x p e c t a t i o n s
t ha t a t t r a c t iv e kind o f policy m e n u d o e s n 't exist, as w e
i l l u s t r a t e in F i g u r e 4 c .
T h e l a s t p a n e l i n F i g u r e 4 r e p e a t s t h e s a m e P ol i c y
s i m u l a t i o n as i n t h e f i r s t p a n e l — m o n e y g r o w t h r a t e a t 6
p e r c e n t — b ut w i t h t h e mod el ad ju st e d so t h a t price
exp ectatio n s are " r a tio n a l." (T h e s e sim ulation s are
t a k e n f r o m a s t u d y p r e p a r e d b y P a u l A n d e r s o n [ l ] o f t hi s
Bank's staff.) T h e resulting path, traced out by the
s i m u l a t i o n , s h o w s d r a m a t i c a l l y a c c e l e r a t i n g i n f l a t i o n as
t h e m a i n a c h i e v e m e n t o f e x p a n s i o n a r y po l i c y. A f t e r f i v e
q u a r t e r s , u n e m p l o y m e n t is still in t h e n e i g h b o r h o o d o f 5
percent, but the inflation rate has soared to 8.5 percent,
and th at s e e m s clearly an u n a cc e p ta b le " t r a d e - o f f " fo r
pu b l i c pol i c y.
W h i l e t h i s i l l u s t r a t i o n is c o n s t r u c t e d t h r o u g h t h e
u s e o f o n e s pe c i f i c , s m a l l e c o n o m e t r i c m o d e l , t h e s a m e

general o u tc o m e would occur using o th e r w ell-k no w n
m a c r o e c o n o m i c mod els, large and small. T h e s e re su lt s
v i v i dl y p o r t r a y t h a t r a t i o n a l e x p e c t a t i o n s h a s a d r a m a t i c
e ffe c t on w h a t e c o n o m i s t s ' mo dels predict the impa ct of
policy decisions to be on t h e e c o n o m y . In a ra ti ona l
e x p e c t a t i o n s worl d, e c o n o m i c policy ac t io n s simply d on't
w o r k t h e w a y m a n y people ha v e believed t h e m to w o rk .
Let's be clear ab o u t w h a t has b e e n ruled o u t by the
r e s u l t s w e ' v e s h o w n : T h e y r u l e o u t a n y n e t g a i n s in
e m p lo y m e n t and outpu t fro m routine countercyclical
pol i c y. T h a t ' s b e c a u s e p e o p l e , o n a v e r a g e , c a n r e c o g n i z e
t h e i n c i p i e n t s t a g e s o f r e c e s s i o n as w e l l a s g o v e r n m e n t
p o l i c y m a k e r s c a n , a n d s o p e o p l e wi l l a n t i c i p a t e t h e
g o v e r n m e n t ' s s t i m u l a t i v e a c t i o n s as l o n g as t h o s e
a c t i o n s a r e a p pl i e d c o n s i s t e n t l y a n d s y s t e m a t i c a l l y f r o m
o n e b u s i n e ss cycle to t h e nex t.
B u t n o t o n l y is t h a t k i n d o f c o n s i s t e n t , o r d e r l y
a p p l i c a t i o n o f c o u n t e r c y c l i c a l p o lic y ru le d o u t as
i n c a p a b l e o f i m p r o v i n g l e v e l s o f r e a l a c t i v i t y in t h e
e c o n o m y o v e r a l l , s o a l s o a r e any a g g r e g a t e s t i m u l a t i v e
policy m e a s u r e s t h a t are readily pred ictab le o r are
p u b l i c l y a n n o u n c e d . F o r t h e y , t o o , wi ll b e c o m e a p a r t o f
people's e xp e c t a t io n s.
S u r p r i s e m o v e s i n po l i c y c a n o f c o u r s e g e t p e o p l e t o
do t h i n g s t h e y h a d n ' t o t h e r w i s e p l a n n e d to do.
T h e r e f o r e , a c t i v i s t d e m a n d m a n a g e m e n t p o l i c y c a n , if
th e m a g n i t u d e o f t he policy st im u l u s e xc e e d s people's
e x p e c ta tio n s , c au s e an addition to e m p l o y m e n t b e y o n d
w h a t w o ul d h a v e o c c u r r e d w i t h o u t policy action. B u t
that qualification should o ffe r no particular e n c o u ra g e ­
m e n t t o s u p p o r t e r s o f a c t i v i s t pol i c y. F o r e v e n t h e t h e o ­
retical possibility o f re pe a te d e sc al at ion s o f g o v e r n m e n t
s t i m u l u s m u s t b e l i m i t e d : F i r s t , b e c a u s e p e o p l e wi l l c a t c h
o n t h a t e s c a l a t i o n h a s b e e n a d o p t e d as a s t r a t e g y a n d
build t h a t s t r a t e g y i nt o th e i r e x p e c t a t io n s ; and second ,
b e c a u s e e sca la tin g inf la tio n ra t e s and loss o f c o n f id e n c e
in g o v e r n m e n t w o u l d p o s e i n c r e a s i n g l y t r o u b l e s o m e
p r o b l e m s t o t h e c o n t i n u i t y o f g o v e r n m e n t a n d its p o l ­
icies. T h e r a t i o n a l i s t s s e e n o c o n s t r u c t i v e r o l e f o r
po l i c i e s t h a t d e p e n d o n “ s u r p r i s i n g " o r “ f o o l i n g " p e o p l e
i n t o d o i n g t h i n g s . W e ' l l c o n s i d e r t h a t i s s u e a b i t m o r e in
the last section.

C on v en tion a l policy stim u lu s in a s lack econom y.
T h e r e is a w i d e l y h e l d v i e w t h a t s a y s , if t h e e c o n o m y is
o p e r a t i n g w i t h a g r e a t deal o f slack, o r “ e x c e s s c a p a c i t y , "
a n y p o l i c y - s p e n d i n g s t i m u l u s wi l l h a v e l i t t l e e f f e c t o n
p r i c e s a n d wi ll m a i n l y r e s u l t in a n i n c r e a s e d r e a l q u a n t i t y
o f o u t p u t . O n l y w h e n t h e e c o n o m y n e a r s “c a p a c i t y "
o u t p u t , c l a i m s t h a t v i e w , wi l l e x t r a s t i m u l u s s p e n d i n g
fail t o b r i n g f o r t h m u c h n e w p h y s i c a l o u t p u t a n d i n s t e a d
be largely dissipated on price inc re as e s . N e i t h e r e c o ­
n o m i c t h e o r y n o r empirical ev ide nce s u p p o r ts t h a t view.
T h e r e is n o c o m p e l l i n g t h e o r e t i c a l r e a s o n t o b e l i e v e
t h a t s o m e ki nd o f cri ti ca l p o i n t e x i s t s in t h e e c o n o m y ' s
overall scale o f o p e r a t i o n t h a t a b ru p t ly d is tin gu is he s




pr i c e- q u a n t i t y r e s p o n s e s t a k i n g place a b o v e t h a t p o in t
f r o m t h o s e ta ki ng place b e lo w . T h a t d o e s n 't m e a n t h a t
physical c o n s t r a i n t s o r b o t t l e n e c k s m i g h t n o t o c c u r at
t h e i n d i v i du a l p l a n t o r i n d u s t r y l e v e l t o t e m p o r a r i l y
block o u t p u t i n c r e a s e s f r o m o c c u r r i n g in r e s p o n s e to
s t r o n g e r d em an d . B u t f o r t h e e c o n o m y as a w h o l e ,
su b s t it u ti o n possibilities a re e n o r m o u s , so s p e n d in g can
shift to o t h e r lines o r s e r v i c e s w h e r e b o t t l e n e c k s o r
c o n s t r a i n t s wi l l n o t , i n g e n e r a l , b e r e a c h e d a t t h e s a m e
time. T h u s , th e e c o n o m i c c o n c e p t o f a g g r e g a t e p r o d u c ­
tion s u g g e st s on ly gr a d u a l t r a n s i t i o n o f c os t, price, and
p ro fita b ility r e la t io n s h ip s o v e r th e full r a n g e of
o p e r a t i n g level s f o r t h e e c o n o m y as a w h o l e .
T h e o b s e r v e d Phillips r e l a t io n s h i p (see, f o r e x a m p l e ,
F i g u r e 3), w h i c h d o e s n o t in g e n e r a l e x h i b i t a s h a r p b e n d ,
p r o v i d e s a r o u g h , p r a c t i c a l v e r i f i c a t i o n t h a t s u c h is t h e
c a s e . A n d t h a t o u g h t t o i n d i c a t e , t o t h o s e w h o still
b e li ev e in a n e x p l o i t a b l e Phi ll i ps c u r v e , t h a t t h e pol ic y
m a k e r gets no “ f r e e r i d e" as t h e e c o n o m y ex p a n d s
f r o m i t s l o w p o i n t s i n r e l a t i v e o p e r a t i n g l e v e l s.
T h e r e is f u r t h e r e m p i r i c a l e v i d e n c e t o t h a t p o i n t :
o n e o f o u r s t u d i e s [2] , u s i n g d a t a f o r t h e U n i t e d S t a t e s
econ om y, has s h o w n th a t the rep o rted capacity
utilization ra te does n o t help e xp la in in f l a ti o n ra t e s
w h e n t he e f f e ct s o f o t h e r f a c t o r s b e a r i n g o n price
c h a n g e s a r e a n a l y t i c a l l y s e p a r a t e d o u t . T h a t is, w h a t e v e r
the caus e o f price level c h a n g e s , t h a t c a u s e d o e s n 't
a p p e a r t o a c t a n y d i f f e r e n t l y w h e n e x c e s s c a p a c i t y is
h i g h t h a n w h e n i t is l o w .
It' s t r u e t h a t a g o v e r n m e n t m o n e t a r y o r s p e n d i n g
s t i m u l u s s o m e t i m e s wi l l b e d i s s i p a t e d n e a r l y t o t a l l y in
p r i c e i n c r e a s e s . A t o t h e r t i m e s it wi l l b r i n g f o r t h g r e a t e r
p h y s i c a l q u a n t i t i e s o f g o o d s a n d s e r v i c e s b u t only w h e n
a c c o m p a n i e d b y a n i n c r e a s e in p r i c e s . T h e d e t e r m i n i n g
fac to r b e t w e e n t h e s e t w o a l t e r n a t i v e s ha s n o t h i n g to do
w ith “capacity u tiliz atio n ," b u t inste ad d ep en ds on
w h e t h e r o r n o t t h e s t i m u l u s h a s b e e n anticipated b y p e o p l e
w h o m a k e b u y -a n d -se ll dec is io ns in th e e c o n o m y .
In s u m m a r y , t h e r e is n o a c t i v i s t p o l i c y — a t a n y l ev e l
of e xc e ss cap acity — t h a t do es n o t b ri ng f o r t h price
i n c r e a s e s a t t h e s a m e t i m e it c a u s e s o u t p u t e x p a n s i o n ,
a n d n o w h e r e d o e s t h e r e l a t i v e a m o u n t o f o u t p u t vs.
p r i c e r e s p o n s e c h a n g e g r e a t l y a s “ e x c e s s c a p a c i t y " is
u s e d up.

IV. Some conclusions: given the new view —
what can macroeconomic policy really do?
T h e pol icy v i e w b u i l t a r o u n d r a t i o n a l e x p e c t a t i o n s ideas
does n o t a r g u e t h a t m o n e t a r y a c t io n s by t h e Fe d e ra l
R e s e r v e and fiscal a c tio n s by C o n g r e s s and the
A d m in is t r a t i o n c a n 't h a v e an e f f e c t on p r o d u c t i o n and
e m p l o y m e n t . T h e y c a n a n d do, b u t o n l y w h e n t h e y
s u r p r i s e pe o p l e .
As w e 'v e r e p e a t e d l y e m p h a s i z e d , a crucial d is t in c ­
t i o n r e q u i r e d b y t h e n e w v i e w is t h a t b e t w e e n p o l i c y
act ion s th at are e x p e c t e d and policy ac t io n s t h a t are

11

s u rp r is e s — o nl y th e l a t t e r c au se people to alter th e i r
e x p e c t a t i o n s a b o u t o p p o r t u n i t i e s for gain and h e n c e to
adjust their planned behavior.

a n d l o g i c a l w a y , it is n o t p o s s i b l e t o d i s t i n g u i s h
g o v e r n m e n t po l i c y m a k i n g f r o m a r a n d o m , o r e v e n
perverse, game.

In th e case o f policy a c t io n s th at are expec te d, the
n e w v i e w a r g u e s t h e r e is n e i t h e r a n e m p i r i c a l n o r
t h e o r e t i c a l b a s i s f o r b e l i e v i n g t h e y c a n b e e x p l o i t e d by
p o l i c y m a k e r s f o r a n y b e n e f i c i a l r eal e f f e c t . I n c l u d e d in
t h i s c a t e g o r y a r e p r e d i c t a b l e po l i c i e s s u c h as t h e F e d e r a l
R e s e r v e ' s traditional " l e a n i n g against the w in d " (which
is t o s a y b e i n g " e x t r a " r e s t r i c t i v e in s u p p l y i n g r e s e r v e s
w h e n t h e e c o n o m y a p p r o a c h e s h i gh o p e r a t i n g rat es and
b e in g " e x t r a " liberal w h e n t he e c o n o m y has be gu n to

A t a d e e p e r l eve l , r a t i o n a l i s t s d o u b t t h a t it w o u l d be
wi se , o r fair, f o r t h e g o v e r n m e n t t o a t t e m p t " p o l i c y by
s u r p r i s e " e v e n if p o lic y m a k e r s w e r e s u f f i c i e n t l y
resourceful to invent unendingly n ew surprise ways to
boost the m o n e y supply and g o v e r n m e n t spending.

s l u m p ) , a s l o n g a s t h a t l e a n i n g is d o n e c o n s i s t e n t l y . T h e
o n l y e c o n o m i c e f f e c t o f e x p e c t e d po l i c y a c t i o n s , if o n t h e
s t i m u l u s s i de , w o u l d b e t o b o o s t g e n e r a l i n f l a t i o n .
P o l i c y a c t i o n s t h a t c o m e as a s u r p r i s e t o pe o p l e , o n
t h e o t h e r h a n d , wi ll , in g e n e r a l , h a v e s o m e r e al e f f e c t s .
P ol i cy s u r p r i s e s c a u s e p e o p l e t o c h a n g e t h e i r pl ans,
b e c a u s e t h e e x p e c t a t i o n s on wh ic h t h e y based t h o s e
plans ha v e b e e n jolted. In t h e technical lit era tu re, m u c h
o f t h e d e f e n s e o f a c t i v i s t po l i c y a g a i n s t t h e r a t i o n a l
e x p e c t a t i o n s a t t a c k h a s h i n g e d o n p r e s e r v i n g w a y s in
w h i c h s u rp r is e could c o n t i n u e to provide w o rk ab le
l e v e r a g e f o r th e policy m a k e r , e v en t h o u g h decision
agents are g ranted rational expectations. We've already
d i s c u s s e d a f e w o f t h e s e a r g u m e n t s — f o r o n e , t he i dea
t h a t peo ple lock t h e m s e l v e s into c o n t r a c ts on prices or
w a g e s . T h i s , a c t i v i s t s a r g u e , e n a b l e s po l i c y m a k e r s t o
u s e s u r p r i s e w h e n n e e d e d , b y c a t c h i n g p e o p l e in
m i d c o n t r a c t , t o f o s t e r a p a r t i c u l a r po l i c y o b j e c t i v e . W e
p o i n t e d o u t in s e c t i o n II w h y t h a t a r g u m e n t is f a u l t y .
A n o t h e r a c t i v i s t i de a is t h a t g o v e r n m e n t pol i c y m a k e r s
have be tte r in fo rm a tio n or superior knowledge about
h o w t h e e c o n o m y w o r k s , and so t h e y can take an action
t h a t p e o pl e w o n ' t c a t c h o n to, at l east f o r a l on g e n o u g h
ti m e t o e n a b l e s o m e policy results. T h e pre m ise a b o u t
s u p e r i o r k n o w l e d g e in t h e g o v e r n m e n t s e c t o r is c l e a r l y
f a u l t y , a n d s e c t i o n II t a l k e d a bi t a b o u t t h e e f f i c i e n c y o f
private sector inform ation.
T h e s e a r g u m e n t s a r e a t b e s t a t t e m p t s t o p a t c h up
q u e s t i o n a b l e p o l i c y t h e o r y b y f i n d i n g s pe c i a l c o n d i t i o n s
u n d e r w h i c h t h e policy o f " s u r p r i s e " can be rou tin e ly
u s e d b y g o v e r n m e n t t o s m o o t h o u t s w i n g s in t h e
b u s i n e s s c y c le . R a t i o n a l i s t s d o u b t , at o n e level o f
q u e s tio n in g , t h a t s ta bi liz ati on e f f o r t s based on surp rise
really give t h e policy m a k e r m u c h to w o r k with. T o the
e x t e n t s u rp r is e policy i n v o lv e s a delib era te s t r a t e g y of
f o o l i n g p e o p l e (in t h e s e n s e t h a t h a d t h e p e o p l e o n l y
k n o w n the tru th they wouldn't have done what the
g o v e r n m e n t ' s a c t i o n g o t t h e m t o do) it m a y e a s i l y w o r k
t h e f i r s t t i m e , b u t t h e n fail t o be e f f e c t i v e t h e s e c o n d o r
third time b e c a u s e people ha v e escalated their a w a r e ­
n e s s o f w h a t g o v e r n m e n t is l i kel y t o d o in a n y g i v e n
s i t u a t i o n . A n d u n l e s s t h e " s u r p r i s e - t h a t - w o r k s " is l a t e r
r e p e a t e d , u n d e r s i m i l a r c o n d i t i o n s a nd in a c o n s i s t e n t


12


O n e o f t h e m o s t i m p o r t a n t ideas e m e r g i n g f r o m t h e
n e w v i e w , a s w e p o i n t e d o u t in s e c t i o n III, is t h a t t h e
" b u s i n e s s c y c l e " m i g h t a t l a s t b e a d e q u a t e l y e x p l a i n e d as
a p r o p e r t y o f a p r o p e r l y w o r k i n g m a r k e t e c o n o m y . In
s u c h a v i e w, i ndi vi du al s a r e t h o u g h t t o r e a c t t o p r of i t
i nc en t iv e s and to i m p e r f e c t ly e x t r a c t i n f o r m a t i o n a b o u t
t h o s e i n c e n t i v e s f r o m c h a n g e s i n p r i c e s i g n a l s t h a t a r e in
p a r t u s e f u l i n f o r m a t i o n a n d in p a r t m e a n i n g l e s s " n o i s e . "
A n e c o n o m i c s y s t e m do ing t h e m o s t ef f ic i en t possible
j o b o f r e a d i n g t h e i n f o r m a t i o n b e i n g r e f l e c t e d in p r i c e
s i g n a l s wi l l still e x p e r i e n c e s o m e i r r e d u c i b l e b u s i n e s s
cycle sw in gs . T h a t ' s b e c a u s e t h e e c o n o m i c pr o c e ss
contains in h e re n t m e ch a n ism s that con v ert random
sh o ck s o n prices int o a m o r e pe rs is te n t, s h o r t - t e r m
misreading of changing profit opportunities. W h e n
m is rea d by e n o u g h people, t h a t a c tio n can s t im u l a t e a
c u m u l a t i v e s w i n g i n o u t p u t t h a t wi ll c o n t i n u e u n t i l t h e
m i s r e a d i n g is r e a l i z e d a n d r e t r e n c h m e n t s e t s i n.
R a n d o m sho ck s to prices and m a r k e t s are al ways w ith
us. S o m e a r i s e f r o m n a t u r a l c a t a s t r o p h e s o r m a n - m a d e
e m b a r g o s , b u t L u c a s [3] a r g u e s t h a t a n i m p o r t a n t s o u r c e
o f s h o c k s to prices m a y ha v e b e e n err atic " s u r p r i s e "
ac tio ns by policy m a k e r s t h e m s e l v e s .
T h e n ew view con jectu res that som e a m o u n t of
c yc l i c a l s w i n g in p r o d u c t i o n a n d e m p l o y m e n t is i n h e r e n t
in t h e micro l ev e l p r o c e s s e s o f t h e e c o n o m y t h a t n o
g o v e r n m e n t macro po l i c i es c a n , o r s h o u l d a t t e m p t t o,
s m o o t h o u t . Expected a d d i t i o n s t o m o n e y g r o w t h c e r t a i n l y
w o n ' t s m o o t h o u t c y c l e s , if t h e a r g u m e n t s in t h i s p a p e r
a r e c o r r e c t . Surprise a d d i t i o n s t o m o n e y g r o w t h h a v e t h e
p o t e n t ia l to m a k e m a t t e r s w o r s e . T h a t ' s b e c a u s e
s u r p r i s e po l i c i e s , a n d t h e p r o s p e c t o f o t h e r f u t u r e
s u r p r i s e po l i c i e s , l e ad t o g r e a t e r u n c e r t a i n t y in p e o p l e ' s
e x p e c t a t i o n s a b o u t f u t u r e prices, w a g es , and in t e r e s t
r a t e s — a n d t h o s e a r e p r i m e i n g r e d i e n t s in p e o p l e ' s
o n g o i n g decision m a k in g. T h e s e n e w th e o r i e s say the
i n f o r m a t i o n v a l u e o f p r i c e s i g n a l s is eroded b y e r r a t i c a n d
u n pr e d ic ta b le g o v e r n m e n t policy action. G i v e n the
im portance to an efficiently w orkin g m a rket e co n o m y of
i n f o r m a t i o n c o n v e y e d by prices, t he p o te nt ia l of activist
g e n e r a l d e m a n d policy to do c os tl y m i s c h ie f m u s t be
con sidered a serious one. G o v e r n m e n t ' s potenti al to
s y s t e m a t i c a l l y e x p l o i t s u r p r i s e s h o c k s is d r a s t i c a l l y
l i m i t e d in a r a t i o n a l e x p e c t a t i o n s w o r l d .

T h e road a h e a d . . .
If it's t r u e t h a t t r a d i t i o n a l l y p e r c e i v e d a c t i v i s t p o l i c y

goals are u n a t t a i n a b l e t h r o u g h m a c r o e c o n o m i c policy
c h a n n e l s , w h a t g o a l s s h o u l d g u i d e m o n e t a r y a n d f i s c al
pol icy? W h a t s h o u l d m o n e t a r y policy t r y t o do?
O n e stra teg y that seem s con sisten t with the
significant, t h o u g h largely negative, findings o f rational
e x p e c t a t i o n s w o u l d h a v e m o n e t a r y p o l i c y f o c u s its
a t t e n t i o n o n i n f l a t i o n a n d a n n o u n c e , a n d s t i c k t o, a
p o l i c y t h a t w o u l d b r i n g t h e r a t e o f i n c r e a s e in t h e
g e n e r a l price level to s o m e specified lo w figure. T o be
s u r e , m e r e l y t o a n n o u n c e s u c h a p o l i c y a t t h i s p o i n t in
t i m e w o u l d be a " s u r p r i s e ' 7— p e r h a p s a r a t h e r l a rg e o n e
g i v e n t h e p a s t h i s t o r y o f p o l i c y — a n d is t h e r e f o r e l i ke l y
to have, fo r a period o f time, s o m e e ff e cts on the planned
l evel o f o u t p u t a nd e m p l o y m e n t . B u t t h e r e ' s n o w a y t o
a v o i d s o m e l u r c h i n g w h e n a t r a j e c t o r y is c h a n g e d . A f t e r
a period o f a d j u s t m e n t , so w e 'v e a rg u e d h e re , a stead y
and c o n s i s t e n t pu rsu it o f s o m e publicly k n o w n , m o d e s t
g r o w t h fo r the m o n e y supply would no t have d etr i­
m e n ta l e ffe c ts on e m p lo y m e n t levels b e ca u se the
g e n e r a l p r i c e l ev e l i m p a c t o f m o n e t a r y po l i c y w o u l d be
bui lt i n t o pe o pl e 's e x p e c t a t i o n s .

References Cited
[1]

Anderson,

Paul

A.

"Rational

Expectations

Forecasts

From

N o n r a c i o n a l M o d e l s , " j o u r n a l o f M o n e t a r y E c o n o m i c s, f o r t h c o m i n g .
[ 2]

Bryant,

J ohn, J a m e s

memorandum,

Duprey,

November

and T h o m a s Supel. Un pub li she d

14,

1977,

Federal

Reserve

Bank

of

Minneapolis.
[3]

L u c a s , R o b e r t E. , J r . " U n d e r s t a n d i n g B u s i n e s s C y c l e s , " C a r n e g i e Rochester

Conference

supplement

to

jou rn al

Series
of

on

M on etary

Public

Policy,

Econom ic*.

Volume

N orth

5,

Holland

Publishing C o m p a n y , 1 9 7 7 .
[4]

M u e n c h , T h o m a s J., A r t h u r J. R o l n i c k , N e i l W a l l a c e , a n d W i l l i a m
Wei ler . " T e s t s f or S t r u c t u r a l C h a n g e a n d P r e d i c t i o n I n t e r v a l s for
the Red uce d F o r m s of T w o S t r u c t u r a l M od el s of the U.S.: T h e
F R B - M I T a n d M i c h i g a n Q u a r t e r l y M o d e l s . " A n n a l s of E c o n o m i c a n d
S o c ia l M e a s u r e m e n t . V o l . 3 , N o . 3 ( J u l y 1 9 7 4 ) : 4 9 1 - 5 1 9 .

[5]

S a m u e l s o n , Paul A., a n d R o b e r t M . S o l o w . " P r o b l e m of A c h i e v i n g
a n d M a i n t a i n i n g a S t a b l e P r i c e L e v e l , " A m e r ic a n Economic Review,
Vol. 5 0 , N o . 2 ( M a y 1 9 6 0 ) : 1 7 7 - 2 2 2 .

[6]

S a r g e n t , T h o m a s J. " A C l a s s i c a l M a c r o e c o n o m e t r i c M o d e l f o r t h e
United

S t a t e s , ” j o u r n a l o f P o l it ic a l E c o n o m y , V o l . 8 4 , N o . 2 ( A p r i l

1976):207-37.

G i v e n t h a t s or t of p r im a r y dedication to a lo w er
infla tion path, t h e g e n e r a l o b je ct iv e o f m o n e t a r y policy
s u g g e s t e d by rati ona l e x p e c t a t i o n s o u g h t to be e l im in a ­
tion or red u ctio n of u n ce rta in ty a b o u t the fu tu re
g e n e r a l p r i c e l e v e l — t o m a k e it a s p r e d i c t a b l e a n d
d e p e n d a b l e as p os s i b l e a r o u n d s o m e l o w a v e r a g e r a t e o f
g r o w t h . T h a t c o u r s e , r a t i o n a l i s t s a r g u e , w o u l d do m o r e
t h a n a n y a l t e r n a t i v e m a c r o policy p o s t u r e to c o n t r i b u t e
to l o n g - t e r m s te a d y e c o n o m i c g r o w t h and high
e m p l o y m e n t rates.
W h i l e w e m i g h t h a v e r e a s o n a b l e c o n f i d e n c e in t h e
wisdom of that general strategy, the rational e xp e c ta ­
tions view can o f f e r little o n t he q u e s t i o n of h o w b est to
i m p l e m e n t s uch a policy ope rat io nal ly. T h a t ' s o n e o f th e
un fin is h ed tasks fo r r esearc h . In t h e m e a n t im e , the
b r o a d e r iss ues w e 'v e raised are topics f o r deep re fl e cti o n
a n d d e b a t e b y t h o s e r e s p o n s i b l e f o r d e s i g n i n g a nd
c o n t r o l l i n g t h e e c o n o m i c po l i c i es o f t h i s n a t i o n . T h a t ' s a
responsibility th a t o u g h t also to c o n c e r n in fo rm e d
c i t i z e n s w h o , a f t e r all, wi ll r e a p t h e b e n e f i t s o f g o o d
po l i c i es a n d p a y t h e c o s t s o f p o o r o n e s .




13

Statement of C ondition
(In T h o u s a n d s )
1977

D ecem b er 3 7

1976

Assets
G o l d C e r t i f i c a t e A c c o u n t ........................................................................................................
I n t e r d i s t r i c t S e t t l e m e n t F u n d ................................................................................................
S p e c i a l D r a w i n g R i g h t s C e r t i f i c a t e A c c o u n t ...........................................................
C o i n ...........................................................................................................................................................
L o a n s t o M e m b e r B a n k s ..........................................................................................................
Securities
F e d e r a l A g e n c y O b l i g a t i o n s ........................................................................................
U . S . G o v e r n m e n t S e c u r i t i e s ........................................................................................
T o t a l S e c u r i t i e s .....................................................................................................................
C a s h I t e m s in P r o c e s s o f C o l l e c t i o n ................................................................................
P re m ise s and E q u ip m e n t —
L e s s D e p r e c i a t i o n o f $ 7 , 0 0 9 a n d $ 5 , 3 2 6 .............................................................
O t h e r A s s e t s .....................................................................................................................................
T o t a l A s s e t s .............................................................................................................................

$

225,007
12,659
25,000
9,109
900

$

221,457
229,951
24,000
13,863
—

195,940
2,470,538
2,666,478
572,661

155,333
2,132,514
2,287,847
454,022

30,468
47,206
$3,589,488

31,580
42,370
$3,305,090

$1,999,312

$1,722,536

720,178
—
276,165
7,995
12,772
1,017,110
482,400
29,206
3,528,028

604,185
42,337
398,245
6,600
19,657
1,071,024
432,483
21,867
3,247,910

30,730
30,730
61,460
$3,589,488

28,590
28,590
57,180
$3,305,090

Liabilities
F e d e r a l R e s e r v e N o t e s ................................................................................................................
Deposits
M e m b e r B a n k R e s e r v e A c c o u n t s .............................................................................
D u e t o O t h e r F e d e r a l R e s e r v e B a n k s — C o l l e c t e d F u n d s ......................
U . S . T r e a s u r y — G e n e r a l A c c o u n t ........................................................................
F o r e i g n ........................................................................................................................................
O t h e r D e p o s i t s .....................................................................................................................
T o t a l D e p o s i t s ........................................................................................................................
D e f e r r e d A v a i l a b i l i t y C a s h I t e m s .....................................................................................
O t h e r L i a b i l i t i e s .............................................................................................................................
T o t a l L i a b i l i t i e s .....................................................................................................................

Capital Accounts
C a p i t a l P a i d I n ...................................................................................................................................
S u r p l u s ...................................................................................................................................................
T o t a l C a p i t a l A c c o u n t s ..................................................................................................
T o t a l L i a b i l i t i e s a n d C a p i t a l A c c o u n t s ................................................................


14


Earnings and Expenses
( In T h o u s a n d s )
For the Y e a r Ended D ecem ber 3 I

1976

1977

Current Earnings
I n t e r e s t o n L o a n s t o M e m b e r B a n k s ...........................................................
Interest on U.S. G o v e r n m e n t Securities
a n d F e d e r a l A g e n c y O b l i g a t i o n s ........................................................
All O t h e r E a r n i n g s ...................................................................................................
T o t a l C u r r e n t E a r n i n g s .............................................................................
Current E x p en ses
S a l a r i e s a n d O t h e r B e n e f i t s .............................................................................
P o s t a g e a nd E x p r e s s a g e ........................................................................................
T e l e p h o n e a nd T e l e g r a p h ...................................................................................
P r i n t i n g a n d S u p p l i e s .............................................................................................
R e a l E s t a t e T a x e s .....................................................................................................
F u r n i t u r e and O p e r a t i n g E q u i p m e n t —
R e n t a l s , D e p r e c i a t i o n , M a i n t e n a n c e ................................................
D e p r e c i a t i o n — B a n k P r e m i s e s .....................................................................
U t i l i t i e s .............................................................................................................................
O t h e r O p e r a t i n g E x p e n s e s ................................................................................
F e d e r a l R e s e r v e C u r r e n c y ...................................................................................
T o t a l C u r r e n t E x p e n s e s .............................................................................
E x p e n s e s R e i m b u r s e d o r R e c o v e r e d ...................................
N e t E x p e n s e s ...........................................................................

...................

$

173

$

...................
...................
...................

162,187
336
163,044

144,368
821
145,362

...................
...................
...................
...................
...................

15,674
2,952
577
949
1,577

14,782
2,845
474
874
1,587

..............

1,679
1,567
461
1,745
1,549
28,730
(1,910)
26,820

1,629
1,566
425
1,782
1,522
27,486
(1,437)
26,049

...................
...................
...................
...................
...................
...................

..............

Current Net E a rn in g s ................................................................... ..............
N e t P r o f i t ( o r L o s s ) .........................................................................
A s s e s s m e n t f o r E x p e n s e s o f B o a r d o f G o v e r n o r s ..........................
D i v i d e n d s P a i d .............................................................................................................
P a y m e n t s t o U . S . T r e a s u r y ................................................................................
T r a n s f e r r e d t o S u r p l u s .............................................................................

521

...................
...................
...................
...................
..................

$

136,224
(4,766)
1,383
1,777
126,158
2,140

$

119,313
374
1,176
1,643
114,371
2,497

Surplus Account
S u r p l u s , J a n u a r y 1 ................................................................................................... ...................
T r a n s f e r r e d t o S u r p l u s — a s a b o v e ............................................................. ...................
S u r p l u s , D e c e m b e r 3 1 ........................................................................................... ...................

$
$

28,590
2,140
30,730

$
$

26,093
2,497
28,590

Volume of Operations*
Number

1977

For the Y e a r Ended D ecember 3 1
L o a n s t o M e m b e r B a n k s ...................................
C u r r e n c y R e c e i v e d a n d V e r i f i e d ................
C o i n R e c e i v e d a n d C o u n t e d ........................
C h e c k s H a n d l e d .....................................................
C o l l e c t i o n I t e m s H a n d l e d ................................
Issues, Red em ptions, E xchanges
of U.S. G o v e r n m e n t Securities . . . .
S e c u r i t i e s H e l d in S a f e k e e p i n g ...................
T r a n s f e r o f F u n d s ................................................

mi l l i on
mi l l i on
mi l l i on
mi l l i o n

8.9 mi l l i on
4 7 8 ,7 2 0
8 9 7 ,3 8 6

1977

197 6

million
million
million
mi l l i o n

$59 1 million
1.2 b i l l i o n
83 m i l l i o n
212 billion
2 billion

$ 4 6 6 million
1.1 b i l l i o n
75 m i l l i o n
177 b i l l i o n
1.4 b i l l i on

9.0 mi l l i on
4 4 9 ,5 2 6
785 ,3 3 1

5 7 .7 b i l l i o n
1 0 .2 bi l l i on
762 bi l l i on

52.4 b i l l i o n
9.4 bi l l i on
5 7 6 b i l l i on

326
147
613
649
.3

Dollar A m o u n t

1976
223
145
538
614
.3

‘ Minneapolis and Helena combined.




15

Directors of the
Federal Reserve Bank of Minneapolis
T erm expires D ecem b er 3 7 of indicated year
J a m e s P. M c F a r l a n d , C h a i r m a n a n d F e d e r a l R e s e r v e A g e n t
S t e p h e n F. K e a t i n g , D e p u t y C h a i r m a n
Class A — Elected by M e m b e r B an ks
J o h n S. R o u z ie , P r e s i d e n t ( 1 9 7 8 )
First N ational B ank, B o w m a n , N o rth Dakota
N e l s E. T u r n q u i s t , P r e s i d e n t ( 1 9 7 9 )
N a t i o n a l B a n k o f S o u t h D a k o t a , S i o u x Fal l s, S o u t h D a k o t a
J a m e s H. S m a b y , P r e s i d e n t ( 1 9 8 0 )
C o m m e rc ia l N ational B a n k & T r u s t C o m pany , Iron M o u n ta in , M ichigan
Class B — Elected by M e m b e r B anks
R u ss ell G. C l e a ry , C h a i r m a n and P re si d en t (19 78 )
G . H e i l e m a n B r e w i n g C o m p a n y , I nc. , La C r o s s e , W i s c o n s i n
W a r r e n B. J o n e s , S e c r e t a r y - T r e a s u r e r & G e n e r a l M a n a g e r ( 1 9 7 9 )
T w o D o t Land & Livestock C o m p a n y , Harlow ton, M o n t a n a
D o n a l d P. H e l g e s o n , S e c r e t a r y - T r e a s u r e r ( 1 9 8 0 )
J a c k F r o s t , I nc . , S t . C l o u d , M i n n e s o t a
Class C — A p p o in ted by B oa rd of Governors
J a m e s P. M c F a r l a n d ( 1 9 7 8 )
4 9 0 0 IDS C en ter, Minneapolis, M innesota
C h a r l e s W. P oe, Jr., P r e s i d e n t ( 1 9 7 9 )
M e tro p o litan E co no m ic D e v e lo p m e n t Association ( M E D A )
Minneapolis, M innesota
S t e p h e n F. K e a t i n g , C h a i r m a n ( 1 9 8 0 )
H o n e y w e l l I nc . , M i n n e a p o l i s , M i n n e s o t a
M e m b e r o f Federal A d v is o r y Council
R i c h a r d H. V a u g h a n , P r e s i d e n t a n d C E O ( 1 9 7 8 )
N o r t h w e s t B an corp o ra tion , Minneapolis, M innesota

Directors of the Helena Branch
P a t r i c i a P. D o u g l a s , C h a i r m a n
N o r r i s E. H a n f o r d , V i c e C h a i r m a n
A pp o in ted by B o a rd of Directors
Federal Reserve B a n k o f M in n ea p o lis
W i l l i a m B. A n d r e w s , P r e s i d e n t ( 1 9 7 8 )
N o r t h w e s t e r n B a n k of Helena, Helena, M o n ta n a
G e o r g e H. S e l o v e r , P r e s i d e n t & G e n e r a l M a n a g e r ( 1 9 7 8 )
S e l o v e r B u i c k - J e e p , I nc . , B i l l i n g s , M o n t a n a
L y n n D. G r o b e l , P r e s i d e n t ( 1 9 7 9 )
First N ational B an k, G la sgo w , M o n ta n a
A ppointed by B o a rd of G overnors
P a t r i c i a P. D o u g l a s , P r o f e s s o r a n d S p e c i a l A s s i s t a n t t o P r e s i d e n t ( 1 9 7 8 )
University of M o n t a n a , Missoula, M o n ta n a
N o r r i s E. H a n f o r d , W h e a t a n d B a r l e y O p e r a t o r ( 1 9 7 9 )
Fort Benton, M ontana


16


J a nu ar y 1 9 7 8

Officers of the
Federal Reserve Bank of Minneapolis

January 1 9 7 8

M a r k H. W i l l e s , P r e s i d e n t
C l e m e n t A. V a n Ni c e , F i r s t V i c e P r e s i d e n t
T h o m a s E. G a i n o r , S e n i o r V i c e P r e s i d e n t
Roland D. G r a h a m , S e n i o r Vice P resid en t
J o h n A. M a c D o n a l d , S e n i o r V i c e P r e s i d e n t
M e l v i n L. B u r s t e i n , V i c e P r e s i d e n t a n d G e n e r a l C o u n s e l
Leonard W. Fernelius, Vice President
Lester G. Gable, Vice President
B r u c e J. H e d b l o m , V i c e P r e s i d e n t
D o u g l a s R. H e l l w e g , V i c e P r e s i d e n t
H o w a r d L. K n o u s , V i c e P r e s i d e n t a n d G e n e r a l A u d i t o r
David R. M c D o n a l d , Vi c e P r e s i d e n t
C larence W. Nelson, Vice President
a nd D i r e c t o r o f R e s e a r c h
R o b e r t W. W o r c e s t e r , Vi c e P r e s i d e n t
S h e l d o n L. A z i n e , A s s i s t a n t V i c e P r e s i d e n t
and A s s i s t a n t C o u n s e l
Earl O . B e e t h , A s s i s t a n t V i c e P r e s i d e n t
J a m e s U. B r o o k s , A s s i s t a n t V i c e P r e s i d e n t
Phi l C . G e r b e r , A s s i s t a n t V i c e P r e s i d e n t
G a r y P. H a n s o n , A s s i s t a n t V i c e P r e s i d e n t
Richard C. Heiber, Assistant Vice President
W i l l i a m B. H o l m , A s s i s t a n t V i c e P r e s i d e n t
R o n a l d E. K a a t z , A s s i s t a n t V i c e P r e s i d e n t
M i c h a e l J. P i n t , A s s i s t a n t V i c e P r e s i d e n t
and A s s i s t a n t S e c r e t a r y
R u t h A. R e i s t e r , A s s i s t a n t V i c e P r e s i d e n t
and S e c r e t a r y
C h a r l e s L. S h r o m o f f , A s s i s t a n t V i c e P r e s i d e n t
C o l l e e n K. S t r a n d , A s s i s t a n t V i c e P r e s i d e n t
R i c h a r d B. T h o m a s , A s s i s t a n t V i c e P r e s i d e n t
Jo sep h R. V o g el , C h i e f E x a m i n e r

Officers of the Helena Branch
J o h n D. J o h n s o n , V i c e P r e s i d e n t
Ronald O . Hostad, Assistant Vice President
B e t t y J. L i n d s t r o m , A s s i s t a n t V i c e P r e s i d e n t




17


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102