On the Policy Ineffectiveness Proposition and a Keynesian Alternative

Abstract

One of the most controversial macroeconomic developments of the last decade has been the rise of the so-called 'new classical' (NC) approach to macroeconomic theory and policy. Lucas (I972), Sargent and Wallace (I975), and Barro (I 976) have presented models which combine the Friedman (i968)-Phelps (I970) natural rate theory, with assumptions of market clearing and rational expectations. As is well known, these models deliver the striking result that the mean values of real variables cannot be affected by the government's monetary policy.' The publication of the theoretical work establishing the impotency result led to much empirical testing of the NC models. One of the most successful approaches from the point of view of NC advocates is contained in a series of papers by Barro (I977, I978, I98I), Barro and Rush (I980), and Rush (I986). Recently, Pesaran (I982) has questioned Barro's results and claimed that once an 'implausible assumption' is discarded, Barro's work can be rejected in favour of a Keynesian alternative. Because Pesaran has put forth an explicit counter-model to Barro's work, his results are potentially quite important. This paper examines in detail Pesaran's work and conclusions.