The Role of Expectations in the Choice of Monetary Policy [report]

John Taylor
1982 unpublished
This paper reviews and contrasts different views about the role of expectations in policy research and practice. Recently, two widely different views seem to have dominated the analysis of policy questions. One view, which is referred to as the "new classical macroeconomic" view, is that expectations overwhelm the influence of monetary policy. The other view, which is referred to as the "Keynesian" macroeconomic view, is that expectations are unimportant because people do not adjust to
more » ... ons of policy change. The paper argues that both these views are misleading. It advances a new view of the role of expectations thatis still emerging from current macroeconomic reearch. The new view recognizes the importance of contractual arrangements which prevent a modern economy from adjusting instantaneously to policy changes, even if they are expected. But it also emphasizes that forward-looking expectations influence how these arrangements are set up and how they evolve over time. Recent criticisms of this new view are reviewed, and examples are given to illustrate how quantitative methods that incorporate this view can be used in practice. There has probably never been a concensus among economists about the role of expectations in formulating monetary policy. Today two widely different views seem to dominate policy research and practice. One view, which I will refer to here as the "new classical macroeconomic" view, is that expectations overwhelm the influence of monetary policy, so that even a sudden change in policy, if expected, will have no real effect on the economy. Sometimes simply, but not quite accurately, called "rational expectations," this view implies that a dramatically quick disinflation could be achieved without recession, and also that monetary policy is ineffective in stabilizing output and employment. The other view, which I will refer to here as the "Keynesian" view, is that expectations matter little, either because they are exogenous, or because people are backwardlooking and do not adjust to expectations of policy change. This view is embodied in most econometric models now used for policy evaluation in practice. It implied that unemployment could be permanently reduced by an increase in inflation, and more recently that accommodative monetary policies could prevent recessions by tolerating negligible and temporary increases in inflation)
doi:10.3386/w1044 fatcat:vh2k4vqhnzfe3ltpd5gfipz7ra