Monetary and fiscal policy are therefore interdependent, and it is difficult to analyse the stabilizing role of monetary policy in isolation. One way of avoiding this complex interdependence is to think of monetary policy as 'independent' in the short to medium run, but constrained by or constraining the fiscal deficit in the long run. This procedure also has the merit that monetary stabilization policy - to which we turn next - can be thought about separately from fiscal policy or long-run monetary growth.
I take as axiomatic the role of monetary policy in controlling inflation via the systematic long-run control of money supply growth. The role of monetary policy in stabilizing output fluctuations demands more careful examination. Before the advent of the rational expectations hypothesis, no one doubted that in principle monetary policy could and should stabilize output, given slowly moving price expectations. The debate resolved around three assumptions: that the central bank has up-to-date information at least as good as that available to the private sector, that the central bank has a good model of the economy with which to forecast the effects of policy, and that it is efficient in implementing required policy. Those opposed to an 'activist' monetary policy argued that all three assumptions were invalid and concluded that activist policy would be at least as likely to increase as to dampen fluctuations.
Rational expectations has widened the scope of this debate. Individuals in the private sector incorporate knowledge of the central bank's reactions into their expectations, if these are indeed formed rationally. Under certain conditions this can neutralize the effects of monetary policy on output. In general, rational expectations complicate the economy's responses to stabilization policy, and this raises questions about the desirability of activist policy. An economic theory must upset strongly held policy convictions in order to be noticed and to acquire a following quickly - Keynes and Friedman understood this, and the policy-ineffectiveness proposition advanced by Sargent and Wallace in 1975 proved the point once more. Sargent and Wallace dealt a strong blow to activist policy prescriptions by merely adding the assumption of rational expectations to a standard Keynesian model with an expectations-augmented Phillips curve. They demonstrated that a monetary authority possessing no better information than its private citizens could not have any influence on the behaviour of output by implementing any planned policy action. Only the authority's monetary 'errors', i.e. the deviations from its monetary plan, could affect output.
This proposition had two effects on the economics profession. It created an antipathy to the hypothesis of rational expectations among those committed to monetary stabilization policy. It also generated a voluminous literature searching for ways to generate policy effectiveness. Yet, as Lucas and Sargent later emphasized, the proposition was never intended as more than a cautionary tale, designed to illustrate the general point that monetary policies may have effects very different from those supposed to occur under naive expectations hypotheses. The intended moral was that 'expectations must be allowed for carefully.'
David Peel and I have surveyed the ways in which policy effectiveness may be reestablished in rational expectations models. If one retains the assumption that the government and the private sector have access to the same information, then any nominal rigidity will do the trick. All that is required is that some nominally denominated asset or contract has a maturity longer than the information lags on nominal variables. The intuition is obvious. Suppose the economy experiences a shock at time t, and its effects on prices are perceived in period t+1. Then provided there are some contracts or assets whose value in period t+2 is...