Theory
Prior to the work of Sargent and Wallace, macroeconomic models were largely based on the adaptive expectations assumption. Many economists found this unsatisfactory since it assumes that agents may repeatedly make systematic errors and can only revise their expectations in a backward-looking way. Under adaptive expectations, agents do not revise their expectations even if the government announces a policy that involves increasing money supply beyond its expected growth level. Revisions would only be made after the increase in money supply has occurred, and even then agents would react only gradually. In each period that agents found their expectations of inflation to be wrong, a certain proportion of agents' forecasting error would be incorporated into their initial expectations. Therefore equilibrium in the economy would only be converged upon and never reached. The government would be able to maintain employment above its natural level and easily manipulate the economy.
This behaviour by agents is contrary to that which is assumed by much of economics. Economics has firm foundations in assumption of rationality, so the systematic errors made by agents in macroeconomic theory were considered unsatisfactory by Sargent and Wallace. More importantly, this behaviour seemed inconsistent with the stagflation of the 1970s, when high inflation coincided with high unemployment, and attempts by policymakers to actively manage the economy in a Keynesian manner were largely counterproductive. When applying rational expectations within a macroeconomic framework, Sargent and Wallace produced the policy-ineffectiveness proposition, according to which the government could not successfully intervene in the economy if attempting to manipulate output. If the government employed monetary expansion in order to increase output, agents would foresee the effects, and wage and price expectations would be revised upwards accordingly. Real wages remain constant and therefore so does output, no money illusion occurs. Only stochastic shocks to the economy can cause deviations in employment from its natural level.
Taken at face value, the theory appeared to be a major blow to a substantial proportion of macroeconomics, particularly Keynesian economics. However, criticisms of the theory were quick to follow its publication.
Read more about this topic: Policy-ineffectiveness Proposition
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