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on some different and wrong theory? Critics of the real-bills doctrine

recognize that policymakers have often believed in and even acted on that
fallacious doctrine.12
What reason is there to suppose that people will acquire information sensibly
and use it with sensible theories and models? In part, the argument appeals to
a kind of natural selection. People who act on expectations formed with
inadequate information and poor theories will tend to lose money and positions
of influence in economic life, leaving the field to those who do behave sensibly.
Arbitrage and speculation also enter into the story. If economic variables did
happen to be determined under the predominant influence of people who used
poor information and poor judgment, then others with better information and
judgment could make profits. In so doing they would move the variables into
correspondence with their fundamental determinants. This argument has some
plausibility when applied to prices of things traded on organized markets, such
as securities, standard commodities and perhaps foreign currencies. It applies
less well to variables such as GDP and the unemployment rate. How does one
speculate on those magnitudes in such a way as to move them toward levels that
are in some sense correct?
RE doctrine does not require everyone to behave rationally in the sense
described. It simply requires enough people to behave that way. People have a
profit-and-loss incentive to behave rationally, a weeding out process operates,
and the behavior of the rational people tends to dominate aggregate economic
behavior.
RE doctrine does not say that expectations are correct. Not even rational
people can foresee the future in detail. But expectations will not be systematically and dependably wrong wrong in a particular direction and degree. If
they were, people who perceived the systematic errors could earn profits by
realizing perceived gains from trade, and their transactions would tend to
wipe the errors out. Economists should therefore model behavior on the supposition that expectations are right on average in the light of the best available
information and theory, although perhaps varying widely around the average.
Lucas (1976 [1981] [1987]) draws a related implication of RE in a proposition known as the Lucas critique. Parameters econometrically measured under
one policy regime will not necessarily stay the same under another. (Some
examples of alternative regimes are: gold standard versus fiat money, fixed
versus floating exchange rates, and macro policy under a political administration committed to avoiding inflation versus policy under one known to favor
fighting unemployment even at the risk of inflation.) Parameters are unlikely
to stay the same because people take account of the policy regime in forming
and acting on their expectations.
RE econometricians try to form models that will remain valid across regimes
by taking account of how the perceived regime affects expectations and

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behavior. They look for parameters of structural equations describing aspects

of peoples behavior that remain constant across a range of environments or
regimes, such as parameters characterizing technologies and preferences
(Sargent, 1986, Chapter 1).

EQUILIBRIUM ALWAYS AND MISPERCEPTIONS

The doctrine of equilibrium always comes close to assuming that prices and
wages are so flexible that markets always clear (or should be modeled as if they
do). This doctrine is not logically bound up with rational expectations, and not
all RE writers combine the two doctrines. Yet the two often do occur together.
How do equilibrium always theorists handle the palpable fact that business
fluctuations do occur and that what appears to be severe involuntary unemployment sometimes develops and persists for months or even years? The first
version or strand of equilibrium always invokes the theory of misperceptions,
connected with the Lucas supply function. Focusing on the fact that workers
and firms have incomplete or imperfect information, Lucas presents an equilibrium model of the business cycle (1979 [1981] [1987], pp. 179214).13 The
second version or strand adopts the real business cycle theory, with its emphasis
on shocks to technology and supply conditions.
In the strand based on misperceptions, money has a role to play in business
fluctuations. Markets are still clearing at the going wages and prices, although
people may be supplying and demanding quantities of labor and commodities
based on misinterpretations of what nominal wages and prices mean in real
terms. In an apparent depression, for example, workers are not supplying as
much labor as usual because they mistakenly perceive real wages as too low to
motivate a normal supply.
One scenario of misperceptions goes as follows. Suppose monetary expansion
unexpectedly raises prices in general. Firms recognize that relative to the
increased prices of their own particular products, constant or even somewhat
increased nominal wage rates represent real wage cuts. Accordingly, they
demand more labor. Workers are willing to supply more labor, for they do not
know enough about the prices of the whole range of consumer goods and
services to recognize that the somewhat increased nominal wage rates actually
represent cuts relative to their own cost of living. Because workers are fooled,
actual employment and output rise. Yet all transactors are operating on their
demand or supply curves, even though the labor supply curve has been distorted
by misperceptions of the real wage.
Suppose, conversely, that monetary shrinkage causes an unexpected decline
in the price level. Firms are more aware of the prices of the particular things they
sell than worker-consumers are of the prices of all the things they buy. Constant

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or even somewhat reduced nominal wage rates appear as real increases to firms
but as real reductions to workers, so firms demand and households supply less
labor. Output falls even though everyone is operating on his labor demand or
supply curve (labor supply curves being distorted by misperceptions). In this
view the unemployment that results is voluntary.
The foregoing scenario is based on Friedman (1968a) and focuses on the
fooling of workers. Lucas (1973, p. 333) extends Friedmans model to include
fooling of firms, which misinterpret general price movements for relative price
changes. Lucas also introduces rational expectations into his model instead of
the adaptive expectations used by Friedman. Birch, Rabin and Yeager (1982)
observe that the misperceptions theory has implications at odds with reality
and squares poorly with the equation of exchange. Our pages below elaborate
on these points.
Sargent and Wallace (1975, 1976) show that the misperceptions strand of
equilibrium always, together with the RE doctrine, yields the policy-invariance
proposition. The former attributes output fluctuations to errors in expectations
or perceptions. The latter suggests that people will not make such errors in
response to systematic, predictable, or perceivable monetary or fiscal policy.
Hence, such policies are ineffective in changing output and unemployment.
The emphasis is on systematic policy because that is the kind that people can
catch onto and make allowance for in their setting of wages and prices. For
example, if people come to perceive that every time a recession begins, the
monetary authority increases the money supply, they will anticipate this
response. Instead of marking down their wages and prices in the face of
slumping demand, they will anticipate the monetary expansion and will maintain
their wages and prices or even raise them in line with the expected money
supply increase. The systematic policy will have no real bite.
Unsystematic, random, haphazard policy cannot come to be expected and
allowed for and so will have a real bite. But precisely because such a policy is
pointless and haphazard, its real effects can hardly be systematically beneficial.
The best to be expected of macroeconomic policy is that it be simple, steady,
easy to catch onto, and therefore nondisturbing. This branch of new classical
macroeconomics arrives at almost the same policy recommendations as earlier
monetarists, but by a different route.
Yet it is hard to believe that anticipated monetary expansion would do no
good even in the depths of depression, simply exhausting itself in price and
wage increases. After all, prices and wages are already too high for the nominal
quantity of money. Monetary expansion would increase real cash balances up
to the full-employment level in a simpler and quicker way than through the
slow and painful process of price and wage deflation, with its adverse side
effects on existing debts and through postponement of spending. New classical
economists are disinclined, however, to dwell on this case. They are uncom-

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fortable with the very concept of disequilibrium, especially of the severe and
prolonged kind that a deep depression would represent.
The notion of equilibrium always is hard to accept. It seems more straightforward to recognize that monetary disturbances may disrupt the clearing of
the markets for labor and commodities. Whether or not people suffer from misperceptions, various circumstances including the complex interdependence of
very many separately determined prices and wages keep them from all adjusting
swiftly to market-clearing levels.
What assumptions we should make about flexibility of prices, nearness to
pure competition and the strength of market-clearing forces depend on what
questions we are tackling (compare page 201 above). In tackling microeconomic questions, assumptions about market perfection may be legitimate
simplifications. But in macroeconomic theorizing, departures from market
perfection are close to the center of the story. One reason for some theorists
belief in equilibrium always seems to be that they (for example, Barro 1979,
especially p. 55) are sliding from a warranted skepticism about activist
government policies into an unwarranted attribution of near-perfection to
markets. Yet no human institution is perfect. The imperfection of one, the state,
does not imply the perfection of another, the market. It does not imply the
capacity of the market to cope quickly even with severe shocks. We should not
go too far in personifying markets and attributing powers of coping to them.
Individuals and not markets are the actors in the economic drama.

EQUILIBRIUM ALWAYS AND REAL BUSINESS CYCLE

THEORY
While money does play a role in the theory reviewed in the last section, it has
no role in real business cycle theory, the second strand of equilibrium always.
This theory attributes business cycles to real or supply shocks, such as changes
in technology. Kydland and Prescott (1982) and Long and Plosser (1983) are
two of the seminal articles in this literature. In explaining observed correlations
between changes in money and output, the theory stresses reverse causation.
Instead of changes in the money growth rate causing changes in income, changes
in income cause changes in that rate (King and Plosser, 1984). As in misperceptions theory, unemployment in a recession is voluntary. Government
stabilization policy is unnecessary and even undesirable (see below).
This theory does not fully explain the technology shocks that supposedly
occur. It simply assumes they do exist. In historical fact it is implausible to
blame real disturbances for the major recessions and depressions actually experienced. Instead of being readily attributable to changes in capacities to produce

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output, recessions and depressions exhibit what look like pervasive deficiencies
of demand, pervasive difficulties in finding customers and finding jobs. The
theory ignores the questions of coordination, information and transactions costs.
It usually assumes a representative agent, that is, all individuals are identical.
In effect it considers how Robinson Crusoe might rationally react to technological shocks (Plosser, 1989 [1997a], pp. 399400).
In Figure 1.1, real business cycle theory eliminates the trend line representing potentional output. It assumes instead that real shocks have permanent
effects so that potential output constantly shifts. Since it assumes that actual
and potential output are the same, the equilibria that result are Pareto optimal;
government stabilization policy is not needed and not desirable. Proponents of
the theory often refer to it as dynamic general equilibrium theory. The
consensus model of monetary policy, described on pages 1379 above, merges
the quantitative techniques and methods of this theory with the price stickiness
of new Keynesian economics.
Market clearing is at the core of real business cycle theory, and as we argue
above, equilibrium always is hard to reconcile with the facts. On the other hand,
monetary-disequilibrium theory explains how erratic money has especially
great scope for causing discoordination. It can point to ample historical and
statistical evidence from a wide range of times and places suggesting that erratic
money has in fact been the dominant (which is not to say the exclusive) source
of business fluctuations. Such episodes defy being talked away with the reverse
causation argument. Laidler (1988 [1990a], p. 22n) suggests that the plausibility
of that argument is greatly reduced by the long and variable time lags inherent
in the real-world phenomena discussed in the monetarist literature. We add that
many episodes of money supplies being changed by causes independent of
incomes and price levels also discredit that argument.
Monetary-disequilibrium theory recognizes that monetary disturbances can
have real effects not only in the short run, but also in the long run (see pages
above) . One does not have to resort to real business cycle theory in order to
explain how the Great Depression badly impaired capital formation, leaving
the U.S. economy to recover from a lower productive base than it otherwise
would have.

THE PHILLIPS CURVE TRADEOFF BETWEEN

INFLATION AND UNEMPLOYMENT
In the first chapter of his 2001 textbook, Principles of Economics, Mankiw
looks at the ten principles of economics. The last of these is: society faces a
short-run tradeoff between inflation and unemployment (Mankiw, 2001a, p.