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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 • • 16 • • # # • • UK. 14 • • • 12 • • B e lgium • • • • I» • • i1 <» • i •• • • t ^ • ii> • • • N e the rlands • 1• • 6 , • U.S. _ ^ •G e rm a n y S w itzerland 4 1 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 0 • • •• *• « • • • • < • . : i i • rl (• 2 -2 • i> •J a p a n « • • C anada 8 . • • France 10 • • • • •< • 1 • • • • • 2 # i> 4 • 6 8 10 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