Policy ineffectiveness proposition

“An implication of the Policy Ineffectiveness Proposition is that the sacrifice ratio should be equal to zero”. Explain. Is this statement supported by empirical evidence?

The Phillips Curve states that inflation depends on expected inflation, cyclical unemployment and supply shocks. It is given by the following equation:

Adaptive Expectations

The inflation expectations can be either adaptive or rational. Early New Classical Economics was largely based the assumption of adaptive expectations, which assumes that people form their expectations of future inflation based on recently observed inflation. This assumption implies that in absence of cyclical unemployment or supply shocks, inflation will continue indefinitely at its current rate. It also implies that past inflation influences the current wages and prices that people set.

In this graph, the increase in the stock of money causes the Aggregate Demand curve to move outwards. In the short run, this causes an increase in the output from the natural level, YN to Y1, which corresponds to the intersection point of the new AD curve and the Short Run Aggregate Supply curve, which hasn’t moved. As agents in the economy adjust their expectations in every period, the equilibrium is achieved only in the long run.

In other words, if we suppose that the stock of money in the economy increases, the adjustment towards the long run equilibrium takes time. In each period that agents find their expectations of inflation to be wrong, they incorporate a certain proportion of their forecasting error into their expectations. This means that the long run equilibrium in the economy would only be reached asymptotically. The government would then be able to maintain employment above its natural level by simply increasing the stock of money in the economy.

Rational Expectations:

However, many economists disagree with the assumption of adaptive expectations. New Classical Theory replaced the assumption of adaptive expectations with that of rational expectations.

In the graphs shown above an assumption of rational expectations is made. In the first graph the increase in money supply is anticipated. An increase in the money supply shifts the AD curve outwards. However as this is anticipated, rational agents change their price expectations and the AS curve moves backward. In this scenario, the output level does not deviate from its natural rate and the change is felt in terms of an increase in the price levels. In the second graph, the increase in money supply is unanticipated. The short run AS curve therefore does not immediately shift backwards, leading to a short run increase in the level of output.

To summarise, under this assumption, anticipated monetary policy would have no effect on economic activity. However, stochastic shocks to the economy could have short run effects on economic activity. This theory is known as the Policy Ineffectiveness Proposition. It was proposed by the economists Thomas J. Sargent and Neil Wallace in their 1976 paper titled “Rational Expectations and the Theory of Economic Policy”. According to this proposition, monetary authorities cannot affect the output if the changes are anticipated. Therefore, the only way authorities can affect the real economy is by making monetary policy less predictable. However, this would increase the variability of output around its natural rate and is hence not a desirable policy aim.

Policy Ineffectiveness Proposition and the Sacrifice Ratio:

An important implication of the Policy Ineffectiveness Proposition is that the monetary authorities can reduce inflation without any output or employment cost. If the monetary authorities announce a reduction in the supply of money, agents will lower their inflation expectations proportionately. One can see this result on the basis of the graphs. A reduction in the supply of money would shift the AD curve backwards. Since this decision had been previously announced, rational agents can anticipate this change and accordingly reduce their inflationary expectations, moving the AS curve backwards. This movement has the effect of lowering the price levels without causing any deviations in the level of output. This scenario is known as the Costless Disinflation Proposition. Linked to the Costless Disinflation Proposition is the concept of the Sacrifice Ratio. The sacrifice ratio is basically the loss in output for a reduction in inflation by one percentage point. Under these assumptions since there is no real change in the level of output for the given decline in price levels, the ratio should be equal to zero.

Empirical Evidence:

Estimates of the cost of disinflation vary widely. These estimates, which are measured in terms of the sacrifice ratio have a wide range of values. While some economists argue that a sound monetary policy can reduce inflation without any costs, others estimate that sometimes the sacrifice ratio may have very high values.

Sargent (1982) studied the methods that brought extreme inflation under control in several European countries in the 1920s. These countries included Austria, Hungary, Germany, and Poland. He also studied what was then Czechoslovakia, as it was a country surrounded by other nations that were experiencing extremely high levels of inflation. He studied these countries because of “the dramatic change in their fiscal policy regime, which in each instance was associated with the end of a hyperinflation.” He also noted a rapid increase in the high-powered money supply in the period following the end of hyperinflation.

For Austria he suggested that currency stabilization was achieved very suddenly, and with a cost in increased unemployment and foregone output that was comparatively minor. From the data for Hungary, he inferred that immediately after the stabilization, unemployment was not any higher than it was one or two years later. He posited that this could be because the stabilization process had little adverse effect on unemployment. For Poland, he noted that the stabilization of the price level in January 1924 was accompanied by an abrupt rise in the number of unemployed. Another rise occurred in July of 1924. He argued that while the figures indicated substantial unemployment in late 1924, unemployment was not an order of magnitude worse than before the stabilization. The Polish zloty depreciated internationally from late 1925 onward but stabilized in autumn of 1926 at around 72% of its level of January 1924. At the same time, the domestic price level stabilized at about 50% above its level of January 1924. The threatened renewal of inflation has been attributed to the government’s premature relaxation of exchange controls and the tendency of the central bank to make private loans at insufficient interest rates. The stabilization of the German mark was accompanied by increases in output and employment and decreases in unemployment. While 1924 was not a good year for German business, it was much better than 1923. From the figures, he couldn’t find much convincing evidence of a favourable trade-off between inflation and output, since the year of spectacular inflation, 1923 was a very bad year for employment and physical production. According to the data, there was an evident absence of a trade-off between inflation and real output. However he suggested that the inflation and the associated reduction in real rates of return to high powered money and other government debt were accompanied by real over-investment in many kinds of capital goods.

He concluded his findings by stating that the essential measures that ended hyperinflation in each of Germany, Austria, Hungary, and Poland were, first, the creation of an independent central bank that was legally committed to refuse the government’s demand for additional unsecured credit and, second, a simultaneous alteration in the fiscal policy regime. These measures had the effect of binding the government to place its debt with private parties and foreign governments which would value that debt according to whether it was backed by sufficiently large prospective taxes relative to public expenditures. In each case that he studied, once it became widely understood that the government would not rely on the central bank for its finances, the inflation terminated and the exchanges stabilized. He further saw that it was not simply the increasing quantity of central bank notes that caused the hyperinflation, since in each case the note circulation continued to grow rapidly after the exchange rate and price level had been stabilized.

According his findings for the four countries, one may conclude that his studies supported the costless disinflation proposition. However there have been other studies that do not support this proposition.

In his 1994 paper “What determines the sacrifice ratio?” Laurence Ball examined disinflations from 1960s onwards and considered some moderate inflation OECD countries. He found that the sacrifice ratio increased as disinflation got slower and that it was lower in those countries which had flexible labour contracts. He also concluded that openness had no effect on the ratio. His findings were thus not in tune with the costless disinflation proposition. The policy implication of his conclusion that gradualism makes disinflation more costly was not clear as the shape of the social loss function wasn’t known. However, he concluded that authorities could limit the length of labour contracts to reduce the sacrifice ratio as the problems arising due to disinflation can be minimised because of their larger welfare gains.

His findings were similar to that of Stanley Fischer in his 1984 paper titled “Contracts, Credibility, and Disinflation”. In this paper he calculated the value of the sacrifice ratio to be between 5 and 6 from the data for the United States Disinflation from 1979-1986.

Hoffstetter (2008) has challenged the view that disinflation in Latin American Countries has been carried out at virtually no cost. He suggested some alternative determinants of measuring the sacrifice ratio and by using different methodologies obtained large sacrifice ratios for 1970s and 1980s. Conversely he still obtained negative disinflation costs for the 1990s. He however noted that the impact of tax reforms, appreciation of the real exchange rate the recent history of high inflation may have been factors which contributed to this peculiar result.

Conclusion:

Apart from the findings of Sargent, empirical evidence seems to suggest that the Costless Disinflation Proposition does not hold true in practice and that any policy measures taken to reduce inflation have a negative impact on the output. Hence one can conclude that the sacrifice ratio is not always zero in the real world.

References:

• Ball, L. (1993), “What Determines the Sacrifice Ratio?”, NBER Working Paper Series, Working Paper No. 4306
• Sargent, Thomas J.(1982), “The Ends of Four Big Inflations”, In: Robert E. Hall Inflation: Causes and Effects, University of Chicago Press. p. 41 – 98
• Fischer, S. (1984), “Contracts, Credibility, and Disinflation”, NBER Working Paper Series, Working Paper No. 1339
• Hofstetter, M. (2008), “Disinflations in Latin America and the Caribbean: A free lunch?” Journal of Macroeconomics, 30, p. 327- 345
• Chen, N. (2009), “New Classical Economics (PowerPoint Slides)”, Lecture, Warwick University, unpublished, Retrieved January 13, 2009 from http://www2.warwick.ac.uk/fac/soc/economics/ug/modules/2nd/ec201/details/nce.pdf
• Policy Ineffectiveness Proposition, (2009, April 5), In Wikipedia, the free encyclopedia. Retrieved January 13, 2009, from http://en.wikipedia.org/wiki/Policy_Ineffectiveness_Proposition