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Critically discuss the following statement: “The Sargent and Wallace (1975) model of policy ineffectiveness has no basis in reality. It is of no practical or theoretical value to policymakers and economists alike.”
The Sargent and Wallace (1975) model of policy ineffectiveness is based on the rational expectations theory. Its conclusion is that government policy has no effect on an economies output and employment and therefore governments are incapable of controlling these variables through macroeconomic policy.
Before the Sargent and Wallace theory models were generally based on adaptive expectations, which assume agents make systematic errors. In such a model expectations can only be amended in a backward looking way. This assumes that agents will only react to government policy after it has been implemented. For example if the government announced a policy of monetary expansion agents would not increase their wage and price expectations until after the increase in money supply. This enables the government to keep the employment rate above its natural level and comfortably manage the economy.
This model contradicts the generally held view of many economists that rationality is a key aspect of economics. Sargent and Wallace came up with the policy ineffectiveness proposition through applying rational expectations to a macroeconomic framework. This determined that any government policy designed to alter the natural level of employment would be unsuccessful as agents would foresee the consequences of such a policy. According to the model variations in the natural level of employment can only be achieved through stochastic shocks to the economy. In a scenario where the government policy is to increase the money supply in the hope of increasing output, agents would alter their expectations so as wage and price expectations would be raised. No money illusion occurs; output remains constant due to real wages and prices being unchanged.
The policy ineffectiveness proposition originally appeared to be a major blow to Keynesian economists; however criticism of this model was quick to come with the main criticism being provided by Stanley Fischer (1977), a new Keynesian economist. His criticism was that rigid wages aren’t taken into account; he assumed that wages were ‘sticky’ as workers sign nominal wage contracts which last for extended periods and resultantly don’t respond to maintain equilibrium between supply and demand in the labour market. Workers have based their wage expectations on ‘stale’ information. For example if wages are set for a one year period but the monetary authority can alter their policies more frequently they will be able to respond to shocks which were not foreseen by the workers at the time wages were agreed. This allows the monetary authority to introduce macroeconomic policy which can bring about the desired effects on output an employment.
The theory of rational expectations has been criticised for being unrealistic with Milton Friedman questioning the validity of the assumption. The idea that all agents have perfect knowledge of policy changes and the structure of an economy is attacked by pointing out that even experts differ in opinion, therefore it is wrong to assume that all agents are aware of the true model of the economy otherwise there would be agreement. The assumption that all agents have full knowledge of the economy is described as ‘implausible’ by Marin as economies from time to time undergo major structural change. There are problems in how agents learn about these changes as each agent relies upon rational expectations of other agents rational expectations subsequent to a change. However this has been countered by the argument that not all agents need to have rational expectation forecasts of every variable in the economy, only those which directly affect them. For example an individual worker whose wages are determined through collective bargaining wouldn’t require the same amount of economic information as the trade union official charged with the collective bargaining. Grossman and Stiglitz believed that even when agents are able to form rational expectations, they would not alter their expectations as this would disclose their information to others involve expending effort or money to become informed. This would enable government policy to remain effective in controlling employment and output.
A fundamental aspect of the Sargent and Wallace model is market clearing; where output is determined by the point of intersection between aggregate demand and aggregate supply. Solow criticised this as being unrealistic as in the real world there were examples of high levels of unemployment therefore one of the key assumptions of the model is incorrect. Sargent and Wallace assumed that prices are flexible and are therefore free to adjust accordingly. Critics have pointed out that this doesn’t stand up to real world examples as there are numerous factors which prevent agents from instantly adjusting expectations, also it can be costly to change prices whilst some prices are tied in to long term contracts.
In addition to the criticisms of the Sargent and Wallace model above there is also substantial empirical evidence that macroeconomic policy can have a substantial effect on an economies output and employment. Pereira (2009) provides empirical evidence on the stabilizing role of macroeconomic policy on output from 1955 to 2005. In his conclusion he does however state that ‘the impact of exogenous policies on output has weakened in the recent decades’. This may point to people gaining a greater level of information on the structure of the economy.
In conclusion, the Sargent and Wallace model of policy ineffectiveness has little practical value to economists and policymakers. The criticisms to rational expectations and also the ‘sticky’ wages idea have found large holes in the model, which have exposed it as too unrealistic to be applied in the real world. Sargent has himself recognised that macroeconomic policy could have nontrivial effects in his book Dynamic Macroeconomic Theory. However, the model does hold some theoretical value. It has been used as the foundation for more pertinent theories which play some part in macroeconomic policy, for example Barro and Rush.
Alan Marin (1992): Macroeconomic Policy
Heijdra, Ben and Frederick Van Der Ploeg (2003). Foundations of Modern Macroeconomics
Steven M. Sheffrin (1996): Rational Expectations
Fischer, Stanley (1977). Long term contracts, rational expectations, and the optimal money supply rule. Journal of Political Economy
Grossman and Stiglitz (1980): On the impossibility of informationally efficient markets
Pereira, Manuel C (2009): Empirical evidence on the stabilizing role of fiscal and monetary policies in the US
Sargent, Thomas and Neil Wallace (1976). Rational Expectations and the Theory of Economic Policy, Journal of Monetary Economics
Spencer, Christopher (2009): New Classical and New Keynesian Economics I
Spencer, Christopher (2009): New Classical and New Keynesian Economics II
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