(a) Critically discuss the following statement: “The Sargent and Wallace (1976) model of policy ineffectiveness has no basis in reality. It is of no practical or theoretical value to policymakers and economists alike.”
Firstly, the policy ineffectiveness proposition established by Sargent and Wallace was radical at the time because it challenged the predominantly Keynesian views of economists by proposing that countercyclical monetary policy is ineffective at systematically affecting the level of output around its trend or natural rate when taking agents' rational expectations into account. This proposition has roused controversy over its validity in reality, which I will analyse in this essay and come to a conclusion as to whether or not it has had any practical or theoretical value.
Policy ineffectiveness proposition (PIP) proposed by Sargent and Wallace (Sargent Wallace) in 1976 can be summarised as countercyclical monetary policy is ineffective at systematically affecting the level of output around its trend or natural rate (y*) when taking agents' rational expectations into account. Therefore one of the fundamental assumptions made by Sargent Wallace in PIP is that the agents (public) know the monetary authority's feedback rule (mt) and takes this into account when forming their expectations of mt at time t-1. This is assumed by means of the monetary authority announcing their policy (mt) or by the agents inferring the parameters (g) of mt from the observed behaviour of the money supply or other variables, so then policy is fully anticipated and neutralised by the price response of agents, shown by the final model for output (yt = ξ0 + ξ2yt-1 + ut + ξ1εt), which contains none of the g parameters of mt. This implies that output cannot be altered by systematic methods but only by surprising or fooling the public into making expectational errors. However this is difficult because if the authority adopted a ‘surprise' policy, the variance of output would increase, implying that the authority should not use unsystematic methods either.
PIP was radical at the time because it challenged the predominantly Keynesian views, which are countercyclical policy-orientated; undermining the adaptive expectations hypothesis (AEH) many macroeconomic models were based on, by suggesting that agents do not make systematic mistakes or cannot be fooled when forming expectations because they are rational; thereby implying that systematic policy is ineffective. Therefore this unsurprisingly, roused much controversy among economists over the validity of PIP in reality because of some the assumptions made by Sargent Wallace.
First of all, PIP derives on rational expectations hypothesis so obviously does not hold if expectations are not rational such as, if the public do not know what the authority's monetary policy rule mt is or only slowly learns it then agents' expectation of prices will lag behind actual prices and output will be higher on average when the authority chooses a higher rate of growth. Notably, there is an absence of a credible theory of how the public learn new policy rules. Another reason given is that PIP relies on the assumption that both the authority and agents have the same information set. This implies that PIP fails if the authority has access to information unknown to agents, or a subset of agents in the private sector have an informational advantage which the government can influence by playing on the expectations and behaviour of the private sector shown by Weiss (1980) and King (1982).
However a more plausible explanation given by Marini (1985, 1986) is that the public and private sector have the same information set but that information is not necessarily complete because in reality, information on interest rates, exchange rates, prices, output and money supply are not all available at the same time. Therefore, partial information could create the opportunity for systematic monetary policy which cannot be anticipated by the public as Marini defines, not only are there expectational surprises due to [pt - E(pt)│Ωt] = εt (where Ωt represents the less than full information set available at time t) but there are further surprises vt, due to the gap between full information Ωt and the partial information set available in the market z, Ωt (z).
More fundamentally, PIP relies on the Lucas aggregate supply function which has attracted the most attacks because it is derived on the assumption that all prices are perfectly ‘flexible'. In particular, Fischer (1977) presents a rational expectations model with over-lapping contracts in two periods to show that the use of longer term nominal contracts puts an element of ‘stickiness' into the nominal wage which means that monetary policy can affect output in the short run. This is supported by Phelps and Taylor (1977) who also argue that prices are ‘sticky' and adjust too slowly to perfectly clear the market, which can be explained by ‘menu costs' involved with price setting and wage negotiations in reality.
Furthermore, other criticisms of PIP include, the models are ‘ad hoc' since they are not derived from the optimisation behaviour of individuals and that they are too simple in their treatment of the monetary policy process because monetary policy relies on more variables in practice. Therefore PIP does not hold in reality because of the underlying weaknesses in the models presented by Sargent Wallace and perhaps explains why PIP has largely been ignored. However, McCallum in his papers on the policy ineffectiveness debate attempts to show that PIP is still valid when prices are ‘sticky', which suggests that PIP cannot be dismissed completely. On the other hand, rational expectations hypothesis (REH) has been significant because it does not necessarily imply the validity of PIP as illustrated by Fischer so it caused economists to reassess the assumptions of macroeconomic models with AEH which had always been at odds with the predominant notion that agents use scarce information wisely.
In conclusion, it has been shown that PIP does not hold in reality because of flaws in some assumptions on which it is based on so it can be argued that it has not had much practical value. However it was one of the first models to illustrate the importance of REH which is of significant theoretical value because REH is now widely accepted as a modelling device by economists, in turn contributing to New Keynesian economics.