276
F
ollowing World War II,
economics was dominated
by Keynesian thinking
(pp.154–61). This claimed that
governments could maintain high
employment through two types of
discretionary policies, which are
introduced to achieve specific goals
through a particular set of actions.
The two types of policy used for
controlling employment were fiscal
policy (government spending and
taxation) and monetary policy
(interest rates and the money supply).
In 1977, two economists—Finn
Kydland of Norway and Edward
Prescott of the US—published a
paper entitled Rules Rather than
Discretion, which argued that
discretionary policy was in fact
self-defeating. Their argument was
based on the concept of rational
expectations, which was developed
by the US economist John Muth
(p.247). Muth argued that since
having incorrect beliefs about
prices is costly, rational individuals
seek to minimize their errors by
planning ahead to avoid this.
Before this, macroeconomic
models had operated on the
assumption that individuals only
look backward, naively expecting
the future to look like the past. TheIf governments can act at their
discretion, they can break
their promises, therefore...This prevents discretionary
government policy
from working.... the government’s
promises are
not credible.Rational individuals forecast
this breaking of promises,
and change their own
behavior to suit.Governments should credibly
commit to following
simple rules, not use
discretionary policy.IN CONTEXT
FOCUS
Economic policyKEY THINKERS
Edward Prescott (1940 – )
Finn Kydland (1943– )BEFORE
1961 John Muth publishes
Rational Expectations and the
Theory of Price Movements.1976 US economist Robert
Lucas argues that it is naive to
model government policy on
solutions that have worked in
the past.AFTER
1983 US economists Robert
Barro and David Gordon
suggest that high inflation
arises from discretionary
government policy and
propose central bank
independence.From 1980s Independent
central banks are established
in many countries worldwide
and commit to simple
policy rules.THE GOVERNMENT’S
PROMISES ARE
INCREDIBLE
INDEPENDENT CENTRAL BANKS