How have I not posted in 8 days? I’ll just post on this topic again, becuase Im sure there is something I’m supposed to be doing.  In the article, Thomas Sargent proposes a method to empirically test Irving Fishers hypothesis about real and nominal interest rates in the face of inflation.  This hypothesis has two formulations:

1) An increase in the rate of inflation will produce an equivalent jump in the nominal yield of bonds over the given time of maturity.   In the long run, a jump in expected inflation will leave the real rate of interest unaltered.  However, in accordance with the Keynesian critique of classical economics, the long run may be too long in the future.  For this hypothesis to work in the short run, “the LM curve is vertical, the IS curve is horizontal, or the Phillips curve is vertical (as it would be in long run).  These assumptions are very monetarist and classicist, along with the conclusion.

2) The more widely accepted Fisher hypothesis is founded on more likely assumptions.  First we must assume that by “rational expectations,” we mean that the public will expect whatever the economic model is able to confirm.  Thus, expectations are exogenous to the model.  Secondly, that the natural rate of unemployment hypothesis is true, and therefore no fiscal or monetary efforts can lower the unemployment rate in the long run.  If we assume these, then the real interest rate is independent from the systematic (M1, I think) part of the money supply and nominal rates are influenced only through expected inflation as influenced by the money supply.  The difference between 1 and 2 lies in the fact that in 2, we make no assumptions about the slopes of the IS LM curves in the short run.   The two assumptions are enough to separate real from nominal rates of interest. 

Sargent, Thomas J.  “Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment.”  Brooking Paper on Economic Activity, Vol 1973, No. 2 (1973), pp 429-480.   

The Address is: http://www.jstor.org/cgibin/jstor/printpage/00072303/di009424/00p0166r/0.pdf?backcontext=page&dowhat=Acrobat&config=jstor&userID=c76f587e@mwc.edu/01c0a8487500507fe6d&0.pdf

This paper takes the form of a playful discussion between two Australian economic students: Bert and Ernie. Bert seems to be arguing for the rational expectations theory, a proposition that boils down to the belief that the average consumer/investor know a lot about future policy, and the effects of that future policy. According to much of Bert’s argumentation, the knowledge and rationality of the average investor will be such that all government policy will be useless. Ernie, however, spends most of his time asking questions and raising objections. Bert begins the article by demonstrating for us graphically the classical monetarist approach; a price and income graph with a vertical supply curve, such that any increase in aggregate demand will translate directly (or in the long run) to a 1:1 increase in the price level.

A note: does the supply curve really have to be vertical, or just extremely inelastic such that prices always increase more than real output, and rather than leaving equilibrium at the point where the supply curve is unit elastic, employers, and consumers would rather stay there. Does this make sense?

Bert contends that the long-run Phillips curve is vertical. That means there is a natural rate of unemployment around which our economy will grow. “Government policy can bring about a departure from that only in the short run and then only by fooling people. But you can’t fool all the people all the time, Therefore, systematic policy is ineffective.” Indeed, later Bert points out that the only way to have any impact on the real output of the economy is by “inducing private agents to have mistaken expectations.” And so in doing this the government can have an impact that supercedes the expectations of the rational agents, however, the impact is likely to be negative and destabilizing

When an employer is deciding whether or not to hire someone, and that person is fully rational and information-imbued, he will need to take into account the future price of labor as well. Therefore, the temporary increase in aggregate demand that our monetary policy has bestowed upon us will not impress our employer. Nor will it impress the laborer, who will also anticipate the increased price level, and hence the later real wage reduction. This argument culminates to its apex on page 300 (of the reader). Why not just use a policy rule? “Any government that relies upon a policy rule—one that has a fixed growth of the money supply—will never cause any deviation from the natural rate. A random policy will affect real output. But any policy rule that is systematically relate4d to economic conditions, for example one designed with stabilization in mind, will be perfectly anticipated, and therefore have no effect on output or employment…to have real effects [it] must be completely unpredictable.”

The significance of this is made clear by Friedman. After WWII, the Phillips curve was god; our government thought that it could systematically exploit the unemployment-inflation dichotomy using aggregate demand. However, rational expectations got in the way, and dissolved the Phillips curve. “If people have rational expectations they wont be fooled by systematic policy even in the short run so there is no scope for short run policy either. This explains why the Phillips curve became unstable the moment policy makers tried to exploit it.

Then Ernie retorts with an argument from the Keynesian model. Monetary expansion leads to an effect on the interest rates that shifts to economy to higher output level. Businesses will expect the increase in aggregate demand and start producing before the demand hits the economy. In this way, monetary policy is actually more effective because of expectations. However, for this to happen, policy makers must take into account the economic effect of the policy, and the expectations effect of the policy, such that their actions are well integrated into both.

Rodney Maddock and Michael Carter.  A Childs Guide to Rational Expectations.  Journal of Economic LIterature (1982) 20, March pp 39-51.