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June 22, 1979
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tional Expectations:
the Trade-Off
When a business recession sets in and unemployment rises, we generally turn to
government to do something about it. If the
government acts
say, by easing credit
conditions
the result could be an increased demand for the output of the
nation's factories and an increase in employment opportunities. The effectiveness
of such stabilization efforts, however, recently has been questioned by some economists and officials. The source of the
controversy is a relatively new theory of the
inflation/unemployment trade-off, one
which combines the notions of rational expectations and the natural-rate hypothesis
- the two ideas which were discussed
separately in our last two Weekly Letters.
The debate has important and far-reaching
consequences for economic policy. Proponents of the new view assert that stabilization pol icies which attempt to"fine-tune"
economic activity are ineffective so that, for
instance, variations in money growth to
combat business cycles are futile. They
conclude that the monetary authorities'
best course is to aim for a steady rate of
growth in the money supply, regardless of
current cyclical conditions, so as to minimize public uncertainty about government
actions.
not altered by inflation - that is, by an
across-the-board increase in prices that
leaves relative prices unchanged - provided the public correctly anticipates the
inflation.
The latter is unlikely always to be the case
because people have only limited information about economic conditions outside
their own markets, and so base their anticipations of inflation largely on their past
experience with inflation, adapting their
expectations to actual conditions only
slowly. Consequently, when the government eases money to combat unemployment, and when inflation accelerates as a
result, individuals believe at first that it is
the relative prices of the goods and services
they sell, and thus their real incomes, that
have increased. Consumers then increase
their real spending, firms demand more
labor, output rises, and unemployment
falls. Policy therefore has an impact on real
economic behavior. The spurt in activity is
only temporary, however, because people
eventually learn that price increases have
been widespread, and accordingly revise
their anticipations and the actions based
upon them. Nonetheless, so long as people's anticipations of inflation systematically lag behind actual inflation, stabilization policy can affect the business cycle.
Casefor stabilization policy
Most economists disagree with this new
view that government efforts to stabi Iize the
business cycle are ineffective. One prevalent view among them attributes cyclical
changes in inflation and unemployment to
people's misperceptions about the actual
rate of inflation. These misperceptions are
the basis for an "expectations-augmented
Phillips Curve" which was discussed in a
previous Weekly Letter. According to this
explanation, people's real spending and
work decisions depend upon the relative
prices of the goods and services they sell.
Thus unemployment and real output are
Rebuttal
Rational-expectations theory says that people use all available information, not simply
past prices, in making forecasts of inflation
and other economic conditions. This notion
is really a refinement of older theories of
expectations, which were generally based
upon the presumption that people forecast in
a reasonably sensible fashion. But rationalexpectations theory goes further by
implying there is no room for stabilization
policy to change output and employment
even for temporary periods of time. It does
Hence, rational expectations joined to the
natural-rate hypothesis leads to the new
view that "fine-tuning" the economy with
monetary policy is eventually futile (once
policy becomes known), so that the authorities' best course is to increase the money
supply at a moderate and steady pace, regardless of the level of unemployment. The
virtue of such a policy is that it is predictable and thus likely to be wellunderstood. Thus people's spending and
working decisions will not be impaired by
misperceptions about government actions.
so by including government stabilization
policies as a vital piece of information used
by the public in forecasting inflation.
Rational-expectations theory asserts that if
monetary policy typically eases when unemployment rises, people will learn to
anticipate this pattern. That is, they come to
realize that when unemployment increases,
money growth and inflation accelerate,
while the reverse happens when unemployment is low -and they use this fact in forecasting inflation.
if we
assume the natural-rate hypothesis, it will
follow that the government's stabilization
policy will cease to affect output and employment because it no longer leads people
to misperceive actual inflation. For example, a rise in unemployment will induce
labor not to seek lower wages but to
demand higher wages in anticipation of
higher money growth. Thus to the extent
that people correctly perceive policy,
actual money changes are incorporated
equally in both actual and anticipated
prices, with little or no change in output or
employment. It follows then that stabilization efforts are ineffective in combatting a
business downturn, as the increased rnoney
growth resulting from an expansionary
policy merely leads to increased inflation.
Rejooll1lderr
Some critics question the realism of the
rational-expectations theory, asserting that
it requires individuals to',have as much
information about the economy as economic experts. Still, individuals need not
gather such information themselves, but
only have access to it -and many private
and public consulting services are available
to provide such knowledge. Under such
conditions, rational-expectations theory requires no more than practically any other
economic theory: namely, that people be
well-informed and act rationally.
Thus the crucial question becomes, how
correct is the implication that predictable
variations in money and prices have no effect upon people's real behavior? Some
believe that even predictable changes in
monetary policy are likely to have an impact upon output and employment at least
in the short-run, after a policy action is
initiated. They assert that institutional
factors -such as labor contracts, worker
seniority and imperfect competitionprevent wages and prices from adjusting
qu ickly to monetary changes. Because of
such market rigidities and sluggish price adjustment, stabilization policy may also
affect output and job-market decisions for a
time.
2
The stakes
inevitable result of a poli.cy of reducing
inflation, even if it is perfectly credible and
perfectly anticipated by the public. Both
views imply that there will be significant
costs to reducing inflation, and both suggest
that a gradual, steady reduction is preferable to an abrupt one.
Although the debate is far from resolved, its
outcome promises to have important implications, both for current anti-inflation
policy and for the longer-term cyclical role
of economic-stabilization policy. If proponents of the new view are correct, "fi netuning" works only as long as the public is
not informed of its details. In the long run,
sophisticated individuals seem bound to
discover the policy-rule, so that if the new
view is correct, monetary policy is best directed at longer-term objectives, and made
as steady and predictable as possible. But if,
as the opponents contend, a predictable
stabilization policy can work because of
the existence of "rigidities," then a policy
of steady growth becomes less desirable,
because it means foregoing opportunities to
reduce fluctuations in unemployment and
real GNP.
Whatever the final outcome of the debate,
rational-expectations theory should leave
us with one important lesson-people's
expectations, which crucially affect their
actions, depend upon their perceptions of
official policies. In the past, economists
often assessed the effects of prospective
policy changes under the assumption that
the public would continue to predict economic conditions in the same way as they
did under the original policy. Rationalexpectations theory implies that such
assessments can be seriously misleading.
Many economists, even those that do not
accept the new view, would concur. Thus
an official who wants to know the likely
outcome of a new policy must first ask how
the public will perceive it. In this way, rational-expectations theory gives renewed
emphasis in economic theory to the credibi Iity and the intentions of government
officials.
However, the two opposing views do not
suggest radical differences in the appropriate policies to be followed for reducing
the present rate of inflation. Reducing inflation entails a change in fundamental
economic policy, and even rationalexpectations theory is vague about how
quickly people's forecasting methods will
adapt in response. Proponents of the new
view argue that to the extent that the publ ic
can be convinced that anti-inflation policy
is genuine and likely to persist, its costs in
terms of sluggish growth can largely be
avoided. However, because of the government's sometimes inconsistent and
unsuccessful policies for curbing inflation,
expectations may not change very quickly.
People will not believe the new policy until
they have seen it operate for some time.
Consequently, perceived wages and prices
are not Iikely to adjust at once to a change
in policy, with the result that for a time
adjustment falls on output and employment. Critics of the new theory bel ieve that
a significant cost in unemployment is the
Rose MclElhattan and Charles Pigott
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BANKDNGDATA-TWEl LfTH IFIEDIERAllIUSERVI
E DBSnUCT
(Dollar amounts in millions)
Se!ectedAssetsarndliabilitiES
large CommercialBanks
Loans(gross,adjusted)and investments*
Loans(gross,adjusted)- total#
Commercial and industrial
Realestate
Loansto individuals
Securitiesloans
U.s. Treasurysecurities*
Other securities*
.Demand deposits - total#
Demand deposits - adjusted
Savingsdeposits - total
Time deposits - total#
Individuals, part. & corp.
(Largenegotiable CD's)
'\/V,E€kly
Averages
of Daily Figures
MemberBanklResell"Ve
Position
ExcessReserves(+ )/Deficiency (- )
Amount
Outstanding
6/6/79
127,559
104,759
30,289
37,518
21 J45
1,745
7 J41
15,059
43,017
31,336
29,927
49,276
40,441
16,437
Weekended
6/6/79
Net U.s. Securitiesdealer transactions
[Loans(+ )/Borrowings(-)]
-
-
1,462
1,582
179
83
131
31
43
163
831
1,614
193
767
303
412
Changefrom
year ago @
Dollar
Percent
+ 17,170
+ 16,256
+ 3,361
+ 8,107
-
+
+
+
+
+
Weekended
5/30/79
NA
NA
242
1,156
3,032
1,721
559
3,747
4,808
1,463
+
+
+
+
-
+
+
+
-
+
+
-
15.55
18.37
12.48
27.56
NA
I'!A
3.03
8.31
7.58
5.81
1.83
. 8.23
13.49
R17
Comparable
year-agoperiod
34
73
39
12
202
- 190
23
37
14
+ 1,684
+ 373
+ 678
407
+ 278
+ 565
Borrowings
Net free reserves(+ )/Net borrowed(-)
Federalfa.mds
- Sevenlarge Banks
Net interbank transactions
[Purchases(+ )/Sales(-)]
Change
from
5/30/79
+
* Excludestradingacceuntsecurities.
# Includesitemsnot shownseparately.
@ Historicaldataare net strictly comparabledueto changesin the reportingpanel;however,adjustments
havebeenappliedto 1978datato removeasmuchaspossibletheeffectsof thechanges
in coverage.
in
addition,for someitems,historicaldataarenot availabledueto definitionalchanges.
Editorialcommentsmaybeaddressed
aotheeditor(WilliamBurke)or to theauthor.... fi'eecopiesof this
andotherfederallReserve
publications
canbeebtainedbycallingor writingthePublicInformationSection,
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Bankof Sanfrancisco,P.O.Box7702,Sanfrancisco94120.Phone(415)544-2184.
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