On Activist Monetary Policy with Rational Expectations

Abstract

The paper examines the case for activist monetary policy. It accepts the view that expectations are formed rationally, but not the implication of flexible price, equilibrium, rational expectations models, that monetary policy cannot and should not be used to affect real magnitudes. The paper starts by asking why the economy has not insulated itself from monetary disturbances through the adoption of indexing and other provisions that would effectively shorten contracts, and suggests that the costs of doing so must be substantial. These costs provide the rational for activist policy, whose aim should be to adjust for aggregate disturbances that the private sector has not made provision to handle. The arguments about activist policy then become those familiar from earlier discussions by Milton Friedman, concerning the long and variable lags with which policy operates, and the alleged propensity of the Fed to misbehave. It is argued that an activist policy that does not respond to minor disturbances, but does respond to actual and prospective major disturbances, would provide a stabilizing force for the economy.