Do Expectations About Policy Matter to the Wage Setting Process The answer to this

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question is crucial to deciding whether activist or nonactivist policy is preferred and so has become a major topic of current research for economists, but the evidence is not yet conclusive. We can ask, however, whether expectations about policy do affect people's behavior in other contexts. This information will help us know if expectations regarding whether policy is accommodating are important to the wage-setting process.

As any good negotiator knows, convincing your opponent that you will be non-accommodating is crucial to getting a good deal. If you are bargaining with a car dealer over price, for example, you must convince him that you can just as easily walk away from the deal and buy a car from a dealer on the other side of town. This principle also applies to conducting foreign policy—it is to your advantage to convince your opponent that you will go to war (be nonaccommodating) if your demands are not met. Similarly, if your opponent thinks that you will be accommodating, he will almost certainly take advantage of you (for an example, see Box 1). Finally, anyone who has dealt with a two-year-old child knows that the more you give in (pursue an accommodating policy), the more demanding the child becomes. Peoples expectations about policy do affect their behavior. Consequently, it is quite plausible that expectations about policy also affect the wage-setting process.8

7The issue that is being described here is the time-consistency problem described in Chapter 21.

8A recent development in monetary theory, new classical macroeconomics, strongly suggests that expectations about policy are crucial to the wage-setting process and the movements of the aggregate supply curve. We will explore why new classical macroeconomics comes to this conclusion in Chapter 28, when we discuss the implications of the rational expectations hypothesis, which states that expectations are formed using all available information, including expectations about policy.

Box 1

Perils of Accommodating Policy

The Terrorism Dilemma. A major dilemma confronting our foreign policy in recent years is whether to cave in to the demands of terrorists when they are holding American hostages. Because our hearts go out to the hostages and their families, we might be tempted to pursue an accommodating policy of giving in to the terrorists to bring the hostages safely back home. However, pursuing this accommodating policy is likely to encourage terrorists to take hostages in the future. V_

The terrorism dilemma illustrates the principle that opponents are more likely to take advantage of you in the future if you accommodate them now. Recognition of this principle, which demonstrates the perils of accommodating policy, explains why governments in countries such as the United States and Israel have been reluctant to give in to terrorist demands even though it has sometimes resulted in the death of hostages.

Rules VerSUS The following conclusions can be generated from our analysis: Activists believe in the

Discretion! use of discretionary policy to eliminate excessive unemployment whenever it devel-

Conclusions ops, because they view the wage and price adjustment process as sluggish and unre sponsive to expectations about policy. Nonactivists, by contrast, believe that a discretionary policy that reacts to excessive unemployment is counter-productive, because wage and price adjustment is rapid and because expectations about policy can matter to the wage-setting process. Nonactivists thus advocate the use of a policy rule to keep the aggregate demand curve from fluctuating away from the trend rate of growth of the natural rate level of output. Monetarists, who adhere to the nonactivist position and who also see money as the sole source of fluctuations in the aggregate demand curve, in the past advocated a policy rule whereby the Federal Reserve keeps the money supply growing at a constant rate. This monetarist rule is referred to as a constant-money-growth-rate rule. Because of the misbehavior of velocity of M1 and M2, monetarists such as Bennett McCallum and Alan Meltzer of Carnegie-Mellon University have advocated a rule for the growth of the monetary base that is adjusted for past velocity changes.

As our analysis indicates, an important element for the success of a nonaccom-modating policy rule is that it be credible: The public must believe that policymakers will be tough and not accede to a cost push by shifting the aggregate demand curve to the right to eliminate unemployment. In other words, government policymakers need credibility as inflation-fighters in the eyes of the public. Otherwise, workers will be more likely to push for higher wages, which will shift the aggregate supply curve leftward after the economy reaches full employment at a point such as point 2 in Figure 11 and will lead to unemployment or inflation (or both). Alternatively, a credible, nonaccommodating policy rule has the benefit that it makes a cost push less likely and thus helps prevent inflation and potential increases in unemployment. The following application suggests that recent historical experience is consistent with the importance of credibility to successful policymaking.

Application Importance of Credibility to Volcker's Victory over Inflation

In the period from 1965 through the 1970s, policymakers had little credibility as inflation-fighters—a well-deserved reputation, as they pursued an accommodating policy to achieve high employment. As we have seen, the outcome was not a happy one. Inflation soared to double-digit levels, while the unemployment rate remained high. To wring inflation out of the system, the Federal Reserve under Chairman Paul Volcker put the economy through two back-to-back recessions in 1980 and 1981-1982 (see Chapter 18). (The data on inflation, money growth, and unemployment in this period are shown in Figures 8 and 10.) Only after the 1981-1982 recession—the most severe in the postwar period, with unemployment above the 10% level—did Volcker establish credibility for the Fed's anti-inflation policy. By the end of 1982, inflation was running at a rate of less than 5%.

One indication of Volcker's credibility came in 1983 when the money growth rate accelerated dramatically and yet inflation did not rise. Workers and firms were convinced that if inflation reared its head, Volcker would pursue a nonaccommodating policy of quashing it. They did not raise wages and prices, which would have shifted the aggregate supply curve leftward and would have led to both inflation and unemployment. The success of Volcker's anti-inflation policy continued throughout the rest of his term as chairman, which ended in 1987; unemployment fell steadily, while the inflation rate remained below 5%. Volcker's triumph over inflation was achieved because he obtained credibility the hard way—he earned it.

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