Knowledge that Transforms

Philip Howrey (1967), William Poole (1970), and John Kareken (1970) initiated a formal debate over monetary policy using some variant of an IS-LM model. Thomas Sargent and Neil Wallace (1975) extend this work by incorporating a Lucas-type aggregate supply function and rational expectations. In spite of the effort spent in following up on the seminal work by Howrey, Poole, and Kareken, little progress has been made in resolving the debate.' The central theme of this paper is that the lack of progress is the result of ignoring homeostasis and the nature of the transmission mechanism. In order to illustrate the importance of homeostasis and the transmission mechanism, this paper extends the standard IS-LM framework in two ways. First it introduces a homeostatic mechanism that generates shortrun responses which correspond to standard IS-LM behavior, and long-run responses which reflect full employment. Second, it provides for alternative transmission mechanisms by dropping the assumption that markets clear continuously. The paper is organized as follows. The model is developed in the next section. The following section examines the role of homeostasis and the transmission mechanism in the debate over policy. The final section presents the conclusions.

Although environmental problems are common in many countries or affect large regions, the threats of carbon dioxide-induced climate change and depletion of stratospheric ozone are perhaps the most credible global environmental problems presently facing humankind. While there are many differences between the CO2 and 03 problems the diffuse, global hazards share a number of common characteristics. The threats are due to anthropogenic chemical changes of a slow, cumulative nature. Early effects may be disguised by normal environmental variation which generates considerable scientific uncertainty. By the time all the mechanisms and consequences are known and evaluated, it may be too late to avoid the majority of effects which may persist for centuries. In addition, the climate or stratosphere so affected is not the property of any individual or nation. The vulnerable natural and social systems require on-going monitoring, research, and risk assessment as uncertainties are defined and, hopefully, reduced. In short these are threats to the global commons for which there is no precedent in human history. This paper examines the different national responses to the threat of chlorofluorocarbon (CFC) depletion of stratospheric ozone as the first of the global atmospheric problems for which nations have taken concrete action beyond scientific study and risk assessment.

Competing views on relationship between government and inflation arise from competing models of inflation. Neo-Keynesian models predict that governments can manipulate aggregate demand by suitable combinations of monetary and fiscal policies, but that effects are asymmetrical: starting from a state of employment, short-term effects of a rise in demand are mainly in a rise in inflation rate and only slightly in a rise in output, while shortterm effects of a fall in demand are mainly in a fall in output and only slightly in a fall in inflation. Throughout this paper I call this the It can also be expressed in terms of a short-term Phillips curve relating real national income to price inflation which is much steeper above than below full employment. This short-term Phillips curve shifts with changes in core inflation rate, defined inflation rate ruling when there are neither demand nor supply-side shock effects on price level. The core rate may depend on expected future inflation these expectations themselves depend on past inflation rates, in Eckstein, or it may depend on inertias, in Tobin, where a concern over relatives makes current wage bargains closely related to past wage bargains. The core rate shifts only slowly because it depends on backward looking behavior. Arthur Okun's posthumously published book contributed greatly to development of micro underpinnings of this model. I have also discussed them in some detail elsewhere (1981). In new classical model, markets clear as they were perfectly competitive. Actual income differs from potential income only if errors are made in predicting rate of inflation which causes firms and/or workers to misperceive changes in money prices and wages changes in relative prices and wages. Expectations of inflation are rational and hence forward looking. If government adopts appropriate policies to raise or lower inflation rate, this leads immediately to a revision of inflationary expectations to which actual inflation rate quickly responds. Thus asymmetry is absent: increases and decreases in aggregate demand have their main effects on increasing or decreasing inflation rate even in short term. The third theory, traditional monetarism, is least explicitly modelled of three. Friedman's statement of its theoretical underpinnings was an IS-LM model closed by a perfectly inelastic aggregate supply curve (AS). Although most economists would accept this long-run AS curve provided long run is enough, agreement on shape of monetarist shortterm AS curve is less obvious. Some would appear to accept virtually inelastic AS curve over this period, while others such Phillip Cagan (1979) and David Laidler (1981) would appear to favor asymmetry. Monetarism has meant different things at different times. Perhaps its most enduring central core is rejection of policy activism and associated k percent rule for monetary expansion. Furthermore many monetarists believe that restrictive monetary policy can be advocated major anti-inflationary tool for governments having threeto five-year political time horizons, that is, they believe in only a short-lived asymmetry at most.

In a recent issue of this Review, Janusz Ordover and Robert Willig present a model of the provision of journals to libraries and individuals. While the provision of journals is itself of interest to academics, the concepts presented have ready extension to a broad class of quasi-public goods. Ordover and Willig treat journals as shared which means that some copies are consumed privately, while others are consumed collectively in libraries. Libraries face one subscription price, individuals another. It is readily recognized that libraries are not necessarily harmful to publishers' profitability, since collective consumption means that more people can be served at any given output. If publishers can appropriate a sufficient share of the value created by library use, they will benefit from collective consumption. Ordover and Willig's treatment of journal pricing incorporates increasing returns to scale in publishing, and the time or inconvenience costs that some readers face in using the library as opposed to using private subscriptions. They argue that because the amount of library use follows from a subscription price that is not equal to marginal cost, library user fees will enhance efficiency in this setting. While the concept of sometimes shared goods is an interesting one, and one which may be useful in some contexts, the model presented by Ordover and Willig imposes implicit and explicit assumptions which cannot be maintained for discussions of policy. This is especially important since their paper makes strong claims of policy relevance and practicality. Even without those claims, these restrictions preclude correspondence of the model to anything in the real world. The restrictions imposed by Ordover and Willig are of two sorts. First, they impose severe restrictions on the demands facing libraries. Second, they ignore all transactions costs except the one which is responsible for all of their results. We maintain that the ignored costs could well be larger than the one that they recognize. We proceed as follows: Section I outlines elements of the model which are essential to our presentation. Section II presents some simple analytics of the type of user fees considered by Ordover and Willig, introduces the policy implications that they draw, and provides the first indication that their results might depend on rather stringent assumptions. Section III demonstrates that the model requires an assumption that the ranking of libraries by willingness to pay is invariant over the domains of a number of key parameters and that this invariance assumption imposes severe restrictions on consumer demands. Section IV discusses restrictions which are fairly explicit in the model, but which are as important as the hidden ones in establishing policy irrelevance. The problems considered in this section are further restrictions on demand and Ordover and Willig's inconsistent treatment of transaction costs.