Knowledge that Transforms

The Lucas-Sargent-Wallace (L-S-W) proposition states that expected policy changes have no influence on real economic variables even in the short run. (See Robert Lucas, 1972, and Thomas Sargent and Neil Wallace, 1975.) One form of empirical test of the L-S-W proposition (the neutrality proposition) began with Robert Barro's (1977; 1978) seminal articles supporting the neutrality proposition. However, more recent papers, including those by David Small (1979), John Makin (1982), and Frederic Mishkin (1982a, b) have reexamined the relationships between anticipated and unanticipated money vs. output, unemployment, and inflation, and have found evidence suggesting that anticipated monetary changes do have real effects. All of the above-cited studies use expectations procedures which estimate, for example, a money growth equation over the entire period under consideration.' However, this approach assumes that when expectations are being formed at the beginning of the period, economic agents have the relevant information for the entire period. In this note I reexamine the impact of expected vs. unexpected monetary changes focusing on the informational restrictions actually faced by economic agents when formulating expectations. The structure of the model used here is similiar to the models of Barro and Mishkin. A measure of real output is assumed to be a function of a policy variable and a vector of predetermined variables. The policy variable can be decomposed into anticipated and unanticipated components. Algebraically:

Suppose that the consumer has the choice among (a) a zero-yield and zero-risk asset, (b) a high-yield and excessively risky asset, (c) a low-yield and zero-risk asset, and (d) some real asset. If we restrict the consumer to the first two, he will select the first one, called In our world in which the consumer has all four choices, he will never select these balances. One economist (see my 1976 paper) wasted almost two pages of the Journal of Economic Literature proving that a consumer will prefer a positive risk-free income to zero income. Three economists (Winston Chang, Daniel Hamberg, Junichi Hirata, 1983) wasted eight pages and some matrix algebra on a renewed effort to persuade the profession of the same thing. Linear extrapolation suggests that a renewed effort will become due in 1990. But the problem is more serious. Given that the demand for speculative balances must be zero, Chang et al. ask (p. 46) why so many texts analyze the demand for them. I would add that these texts go on to raise the specter of a price-theoretic monstrosity-an infinite demand for speculative balances ( the liquidity trap) and its devastating consequences for monetary policy. This is not unusual. Texts give much space to the theory that current consumption is deternmined by unmeasurable future income, about which each of us forms only vague and changeable guesses (see my 1979 paper). The Pigou is explained to undergraduates even though its currency base (Don Patinkin, 1969, p. 1154) is a microscopic fraction of national wealth, and even though the effect is theoretically superfluous (see my 1982 paper). Many other such cases could be mentioned. Let me speculate why pedagogic failures litter our texts. The suppliers prefer to sell thick (expensive) books. Many of the intermediaries attract and impress students by endowing our field with more scientific content than it actually has. And, the captive demanders are not given protection by rigorous and extensive journal reviews of what should be the cornerstone of economics, the textbooks. Thus they are forced-to use Frank Knight's felicitous phrase-to know too many things that just ain't so.