RDP 8605: On Some Recent Developments in Monetary Economics 4. Expectations

The work of Friedman and Phelps in the 1960s,[12] and Lucas in the 1970s,[13] has emphasised that the response of the economy to particular policy actions will depend on the states of individuals' expectations which will in turn depend on perceptions about the policy actions themselves. A corollary is that policy cannot rely on exploiting aggregate relationships which depend on past policies; the attempt to do so may cause the aggregate relationship to break down.

The breakdown of a macroeconomic relationship in this way will require, in practice, a significant change in policy. Individuals will face costs in responding, which may imply that small policy changes will leave responses largely unaffected as they impose costs on individuals which are small relative to the costs of changing behaviour patterns. Over time, of course, a succession of small policy changes could produce a significant cumulative incentive to private individuals to change their behaviour; the costs of changing behaviour may also be reduced by innovation.

The traditional distinction between “rules” and “discretion” in the conduct of policy becomes important here. When changes in policy instruments are dictated by a long-established fixed rule (with feedback from the rest of the economy) – an example is the Gold Standard – they are unlikely to induce major shifts in private responses. When the policy rule changes, or when policy is discretionary (and therefore there is no fixed rule), it is more likely that private responses will change also.

This dependence may also work in reverse. Changes in private behaviour, “innovation” of various kinds, may lead to changes in official response, including the structure of regulations. For example, the increased internationalisation of financial transactions in recent years can be seen both as a cause and effect of reduced exchange controls and flexible exchange rates.

This line of argument suggests that even if simple aggregative relationships such as the money stock-money income equation may be adequate descriptions of particular historical periods, they cannot be exploited for analytical (or policy) purposes. Attempts to exploit simple “reduced form” relationships will be likely to fail.[14]

The effect of significant (and observable) policy changes is shown in recent work by Andersen (1985). His work, which studies the behaviour of different monetary aggregates accross a range of developed economies, showed that the relationship between money and the economy more generally (represented by the demand functions for the different monetary aggregates) depended on the monetary policy in place. In each country, the monetary aggregate which was the focus of policy targeting exhibited a different relationship than other aggregates, suggesting that private individuals responded differently to targeted monetary aggregates than to untargeted aggregates.


M. Friedman (1968) and (1974); Phelps (1968). [12]

Lucas (1976). [13]

As in “Goodhart's Law”; cf Chapter III of Goodhart (1984). [14]