Policy Ineffectiveness Proposition - Essay Example

1. Policy ineffectiveness proposition was proposed by Thomas J Sargent in 1976 and this theory is based upon the rational expectations theory. The rational expectations theory is the basis for the policy ineffectiveness proposition, the rational expectations theory states that the optimal forecast be used to predict the future but this does not take the human judgments into consideration and assumes that humans do not make mistakes which are systematic this theory is in stark contrast with previous economic theories which were actually based on the adaptive expectations theory which says that people form their expectations of the future from what ever has happened in the past for example if inflation rates have been high in the past the people would revise their expectations of the inflation rates in the future because this is what has happened in the past and people would naturally behave in this manner because if this is what has happened in the past then people will expect it to happen in the future as well. By rational expectations it is meant that the government cannot then influence the output of the country because when the government tries to influence the output through monetary expansion then if the rational expectations theory is applied agents would recognize the effects of such a policy before hand and hence would revise their own policy regarding price and wages upwards hence when this takes place the wages and price remain constant and hence also the out put. There have been many criticisms to the theory but the fact remains that this was a pretty acceptable theory in view of the adaptive expectations and rational expectations theory this theory has been a sort of a comparison between the two but never the less his has resulted in to a theory that stands on its own and challenges the integrity and the worth of the some of the oldest and the most well known theories of the macroeconomic sphere. This theory has also come under severe criticism because it has challenged the integrity of macroeconomic theories in general, the most formidable criticism came from Fischer who pointed out that when employees are engaged they are made to sign a contract which then means that they have agreed to work on a pay for a certain amount of time hence making wages sticky, so if the government does decide to influence the output then it would be able to do so because of the sticky wages concept.. another criticism of the theory came from Sanford who pointed out that although the economic agents do have the resources and the mental ability to sort out government policies and then react to it but that is highly unlikely because when they act upon the information that they have gathered then others would follow suit and gain from their actions which is not desirable because every one gains from some one else’s costs. These arguments have made the policy ineffectiveness proposition lose its weight amongst other economic theories. 2. The new Keynesian framework or the new classical monetarist draw upon the classical assumption that price and wage are inherently flexible in nature, this means that the wages and price simply change to adjust to the demand and supply of a product or an industry. Secondly, the new Keynesian framework assumptions draw upon the modern developments in the field of statistics and human behavior. They expect every human to have knowledge about the economy and what the government is trying to do so that no body can be fooled into thinking that the government is doing all that it can to better off the state of the economy when that is not the case or the government announces some policies and then does not pursue them, then the people should know by their own knowledge what the government is in effect actually trying to do. It also assumes that the people and the government have the same amount of information available to them so when the government acts the people would know on what information it is taking action and hence they can take rational decisions. The Keynesians or the new Keynesians also believe that much of the unemployment in an economy is voluntary because people do not want to work and there are various theories supporting this claim, the best one being the misperceptions and the illusory Philips curve. The new Keynesians also have their own way on the fiscal policy known as the ‘Ricardian view of fiscal policy’ which implies that the changes in taxes do not have any effect on the amount of the spending or on the spending level. If the economy is such conditions experiences a demand shock then the first thing to happen would be that the firms will want to produce much more and hence they will want to employ more and more people, if the unemployment is voluntary then these people might not be willing to work at very high wages as well because they have decided to take this time off and would have some definite plans for the whole time off and high wages might not draw every one into working at once so the supply side might not be able to cope up with the demand shock because of the shortage of the skilled labor. As aggregate demand increases the price levels in the economy would over all go up according to the ASAD framework, this would lead to people demanding more money and hence the demand for money increases manifolds, this would lead to higher interest rates according to the ASAD framework . This would lead to the prices going up and since every one in the economy has perfect knowledge firms will tend to raise wages even further and at this point according to the misperceptions theory people would be confused about their status as employees because they would think that their real wage has risen and hence more and more people would tend to drop down from the production lines or the services departments because they feel they are better off and they need a vacation or they need to take a break from their work for the time being this leads to further problems for the firms and also the government because they then need to cope up with this added burden. References 1. nordhaus, samuelson (1997). Economics. Mcgraw Hill Read More