Posted at 12.31.2018
The Sargent and Wallace (1975) style of policy ineffectiveness is dependant on the rational expectations theory. Its conclusion is the fact that government policy does not have any effect on an economies output and employment and for that reason governments are not capable of controlling these variables through macroeconomic policy.
Before the Sargent and Wallace theory models were generally based on adaptive expectations, which assume agents make systematic errors. In that model expectations can only just be amended in a backward looking way. This assumes that agents will only react to government policy after it has been implemented. For example if the federal government announced a policy of monetary expansion agents would not increase their wage and price expectations until following the increase in money supply. This allows the federal government to keep carefully the employment rate above its natural level and comfortably manage the economy.
This model contradicts the generally held view of several economists that rationality is an integral facet of economics. Sargent and Wallace developed the policy ineffectiveness proposition through applying rational expectations to a macroeconomic framework. This determined that any government policy designed to alter the natural degree of employment would be unsuccessful as agents would foresee the consequences of such a policy. Based on the model variations in the natural degree of employment can only be performed through stochastic shocks to the economy. Inside a scenario where in fact the government policy is to raise the money supply in the hope of increasing output, agents would alter their expectations so as wage and price expectations would be raised. No money illusion occurs; output remains constant due to real wages and prices being unchanged.
The policy ineffectiveness proposition originally were a significant blow to Keynesian economists; however criticism of the model was quick to include the key criticism being provided by Stanley Fischer (1977), a new Keynesian economist. His criticism was that rigid wages aren't considered; he assumed that wages were 'sticky' as staff sign nominal wage contracts which last for extended periods and resultantly don't respond to maintain equilibrium between supply and demand in the labour market. Workers have based their wage expectations on 'stale' information. For example if wages are set for a one year period however the monetary authority can transform their policies more frequently they will be able to react to shocks that have been not foreseen by the workers at that time wages were agreed. This enables the monetary authority to introduce macroeconomic policy which can result in the desired effects on output an employment.
The theory of rational expectations has been criticised for being unrealistic with Milton Friedman questioning the validity of the assumption. The idea that agents have perfect understanding of policy changes and the structure of your economy is attacked by pointing out that even experts differ in opinion, therefore it is wrong to assume that agents are aware of the true style of the economy otherwise there would be agreement. The assumption that all agents have full understanding of the economy is referred to as 'implausible' by Marin as economies from time to time undergo major structural change. You will find problems in how agents learn about these changes as each agent relies after rational expectations of other agents rational expectations subsequent to a big change. However this has been countered by the argument that not absolutely all agents need to have rational expectation forecasts of every variable throughout the market, only those that directly affect them. For instance a person worker whose wages are determined through collective bargaining wouldn't require the same amount of economical information as the trade union official charged with the collective bargaining. Grossman and Stiglitz believed that even though agents are able to form rational expectations, they might not alter their expectations as this might disclose their information to others involve expending effort or money to become informed. This might permit government policy to stay effective in controlling employment and output.
A fundamental facet of the Sargent and Wallace model is market clearing; where output is determined by the point of intersection between aggregate demand and aggregate supply. Solow criticised this to be unrealistic just as real life there were examples of high degrees of unemployment therefore one of the key assumptions of the model is incorrect. Sargent and Wallace assumed that prices are flexible and are therefore free to adapt accordingly. Critics have pointed out that this doesn't endure real world examples as you'll find so many factors which prevent agents from instantly adjusting expectations, and yes it can be expensive to change prices whilst some prices are tied in to permanent contracts.
In addition to the criticisms of the Sargent and Wallace model above addititionally there is substantial empirical evidence that macroeconomic policy can have a considerable influence on an economies output and employment. Pereira (2009) provides empirical evidence on the stabilizing role of macroeconomic policy on output from 1955 to 2005. In his conclusion he does however declare that 'the impact of exogenous policies on output has weakened in the recent decades'. This might point to people gaining a greater level of information on the structure of the economy.
In conclusion, the Sargent and Wallace style of policy ineffectiveness has little practical value to economists and policymakers. The criticisms to rational expectations as well as the 'sticky' wages idea have found large holes in the model, that have exposed it as too unrealistic to be applied in the real world. Sargent has himself recognised that macroeconomic policy might well have nontrivial effects in his publication Dynamic Macroeconomic Theory. However, the model does hold some theoretical value. It's been used as the foundation to get more pertinent theories which play some part in macroeconomic policy, for example Barro and Rush.
Alan Marin (1992): Macroeconomic Policy
Heijdra, Ben and Frederick Van Der Ploeg (2003). Foundations of Modern Macroeconomics
Steven M. Sheffrin (1996): Rational Expectations
Fischer, Stanley (1977). Long lasting contracts, rational expectations, and the optimal money supply rule. Journal of Political Economy
Grossman and Stiglitz (1980): On the impossibility of informationally efficient markets
Pereira, Manuel C (2009): Empirical evidence on the stabilizing role of fiscal and monetary policies in the US
Sargent, Thomas and Neil Wallace (1976). Rational Expectations and the idea of Economic Policy, Journal of Monetary Economics
Spencer, Christopher (2009): New Classical and New Keynesian Economics I
Spencer, Christopher (2009): New Classical and New Keynesian Economics II