DP104 | Rational Expectations and Monetary Policy


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This survey essay considers how rational expectations have changed our evaluation of monetary policy. In the first section, various underpinnings of the "Phillips curve" relation between inflation and output are reviewed. All are concluded to be products of particular institutional set-ups whose origins are not well understood. The second section examines the joint implications of (a) the government budget constraint and (b) long-term stationarity of the government debt/GDP ratio. This generates the need for long-run "consistency" between fiscal and monetary policy, as well as a trade-off between current and future fiscal/monetary policy. The third section reviews monetary stabilisation policy. "Policy-effectiveness" will in general exist in rational expectations models in spite of the "shocking" early counter-example of Sargent and Wallace; the real problems relate to the desirability of such policy. The most serious problem is time inconsistency; policies of "reflation" involve reneging on previous counter-inflationary commitments, and models of reputation do not yet suggest this can be prevented without constitutional limitations. The essay concludes that rational expectations have made monetary institutions "more of a mystery than ever before".