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Rabin A Monetary Theory - 216 220
Rabin A Monetary Theory - 216 220
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Monetary theory
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or even somewhat reduced nominal wage rates appear as real increases to firms
but as real reductions to workers, so firms demand and households supply less
labor. Output falls even though everyone is operating on his labor demand or
supply curve (labor supply curves being distorted by misperceptions). In this
view the unemployment that results is voluntary.
The foregoing scenario is based on Friedman (1968a) and focuses on the
fooling of workers. Lucas (1973, p. 333) extends Friedmans model to include
fooling of firms, which misinterpret general price movements for relative price
changes. Lucas also introduces rational expectations into his model instead of
the adaptive expectations used by Friedman. Birch, Rabin and Yeager (1982)
observe that the misperceptions theory has implications at odds with reality
and squares poorly with the equation of exchange. Our pages below elaborate
on these points.
Sargent and Wallace (1975, 1976) show that the misperceptions strand of
equilibrium always, together with the RE doctrine, yields the policy-invariance
proposition. The former attributes output fluctuations to errors in expectations
or perceptions. The latter suggests that people will not make such errors in
response to systematic, predictable, or perceivable monetary or fiscal policy.
Hence, such policies are ineffective in changing output and unemployment.
The emphasis is on systematic policy because that is the kind that people can
catch onto and make allowance for in their setting of wages and prices. For
example, if people come to perceive that every time a recession begins, the
monetary authority increases the money supply, they will anticipate this
response. Instead of marking down their wages and prices in the face of
slumping demand, they will anticipate the monetary expansion and will maintain
their wages and prices or even raise them in line with the expected money
supply increase. The systematic policy will have no real bite.
Unsystematic, random, haphazard policy cannot come to be expected and
allowed for and so will have a real bite. But precisely because such a policy is
pointless and haphazard, its real effects can hardly be systematically beneficial.
The best to be expected of macroeconomic policy is that it be simple, steady,
easy to catch onto, and therefore nondisturbing. This branch of new classical
macroeconomics arrives at almost the same policy recommendations as earlier
monetarists, but by a different route.
Yet it is hard to believe that anticipated monetary expansion would do no
good even in the depths of depression, simply exhausting itself in price and
wage increases. After all, prices and wages are already too high for the nominal
quantity of money. Monetary expansion would increase real cash balances up
to the full-employment level in a simpler and quicker way than through the
slow and painful process of price and wage deflation, with its adverse side
effects on existing debts and through postponement of spending. New classical
economists are disinclined, however, to dwell on this case. They are uncom-
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Monetary theory
fortable with the very concept of disequilibrium, especially of the severe and
prolonged kind that a deep depression would represent.
The notion of equilibrium always is hard to accept. It seems more straightforward to recognize that monetary disturbances may disrupt the clearing of
the markets for labor and commodities. Whether or not people suffer from misperceptions, various circumstances including the complex interdependence of
very many separately determined prices and wages keep them from all adjusting
swiftly to market-clearing levels.
What assumptions we should make about flexibility of prices, nearness to
pure competition and the strength of market-clearing forces depend on what
questions we are tackling (compare page 201 above). In tackling microeconomic questions, assumptions about market perfection may be legitimate
simplifications. But in macroeconomic theorizing, departures from market
perfection are close to the center of the story. One reason for some theorists
belief in equilibrium always seems to be that they (for example, Barro 1979,
especially p. 55) are sliding from a warranted skepticism about activist
government policies into an unwarranted attribution of near-perfection to
markets. Yet no human institution is perfect. The imperfection of one, the state,
does not imply the perfection of another, the market. It does not imply the
capacity of the market to cope quickly even with severe shocks. We should not
go too far in personifying markets and attributing powers of coping to them.
Individuals and not markets are the actors in the economic drama.
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output, recessions and depressions exhibit what look like pervasive deficiencies
of demand, pervasive difficulties in finding customers and finding jobs. The
theory ignores the questions of coordination, information and transactions costs.
It usually assumes a representative agent, that is, all individuals are identical.
In effect it considers how Robinson Crusoe might rationally react to technological shocks (Plosser, 1989 [1997a], pp. 399400).
In Figure 1.1, real business cycle theory eliminates the trend line representing potentional output. It assumes instead that real shocks have permanent
effects so that potential output constantly shifts. Since it assumes that actual
and potential output are the same, the equilibria that result are Pareto optimal;
government stabilization policy is not needed and not desirable. Proponents of
the theory often refer to it as dynamic general equilibrium theory. The
consensus model of monetary policy, described on pages 1379 above, merges
the quantitative techniques and methods of this theory with the price stickiness
of new Keynesian economics.
Market clearing is at the core of real business cycle theory, and as we argue
above, equilibrium always is hard to reconcile with the facts. On the other hand,
monetary-disequilibrium theory explains how erratic money has especially
great scope for causing discoordination. It can point to ample historical and
statistical evidence from a wide range of times and places suggesting that erratic
money has in fact been the dominant (which is not to say the exclusive) source
of business fluctuations. Such episodes defy being talked away with the reverse
causation argument. Laidler (1988 [1990a], p. 22n) suggests that the plausibility
of that argument is greatly reduced by the long and variable time lags inherent
in the real-world phenomena discussed in the monetarist literature. We add that
many episodes of money supplies being changed by causes independent of
incomes and price levels also discredit that argument.
Monetary-disequilibrium theory recognizes that monetary disturbances can
have real effects not only in the short run, but also in the long run (see pages
above) . One does not have to resort to real business cycle theory in order to
explain how the Great Depression badly impaired capital formation, leaving
the U.S. economy to recover from a lower productive base than it otherwise
would have.