Rational expectations and inflation third edition

Rational Expectations and Inflation Rational Expectations and Inflation Third Edition Thomas J Sargent Princeton University Press Princeton and Oxford Copyright © 2013 by Princeton University Press Published by Princeton University Press 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press Oxford Street, Woodstock, Oxfordshire, OX20 1TW All Rights Reserved Library of Congress Control Number: 2013930076 ISBN 978-0-691-15870-9 British Library Cataloging-in-Publication Data is available This book has been composed in LATEX using Peter Wilson’s memoir class The publisher would like to acknowledge the author of this volume for providing the camera-ready copy from which this book was printed Printed on acid-free paper ∞ press.princeton.edu Printed in the United States of America 10 For Anne, Addison, and Ari Contents LIST OF FIGURES LIST OF TABLES ACKNOWLEDGEMENTS PREFACE TO THE THIRD EDITION xi xiii xv xvii PREFACE TO THE SECOND EDITION xix PREFACE TO THE FIRST EDITION xxi RATIONAL EXPECTATIONS AND THE RECONSTRUCTION OF MACROECONOMICS Behavior Changes with the Rules of the Game The Investment Decision Are Government Deficits Inflationary? General Implications of the Examples New Econometric Methods Historical and Cross-Country Analysis Implications for Policymakers REAGANOMICS AND CREDIBILITY Dynamic Games An Economy as a Dynamic Game Are Government Deficits Inflationary? Reaganomics and Credibility Conclusion THE ENDS OF FOUR BIG INFLATIONS 1 10 11 13 15 17 19 21 26 33 36 38 Introduction The Gold Standard Austria Hungary Poland Germany Czechoslovakia Conclusion Appendix STOPPING MODERATE INFLATIONS: THE METHODS OF POINCARÉ AND THATCHER Introduction The “Poincaré Miracle” The British Experience Mrs Thatcher’s Plan The Outcome of the Plan So Far Overshooting the £M3 Target The Government Deficit North Sea Oil and the Pound Sterling Conclusion Second Thoughts Poincaré and Moreau Methods of Thatcher and Reagan Where to Play Chicken 38 42 47 53 58 60 64 66 67 111 111 116 123 124 129 130 132 136 142 143 145 146 SOME UNPLEASANT MONETARIST ARITHMETIC with Neil Wallace 162 Introduction A Simple Monetarist Model The Cagan-Bresciani-Turroni Effect Conclusions and Qualifications Appendix 162 166 171 173 177 Appendix Appendix by Danny Quah 180 193 INTERPRETING THE REAGAN DEFICITS 197 Government Budget Balance Barro Tax Smoothing Wallace’s Game of Chicken Conclusion Appendix Hall’s Model 197 199 204 207 208 Barro’s Model SPECULATIONS ABOUT THE SPECULATION AGAINST THE HONG KONG DOLLAR with David T Beers and Neil Wallace A Look at Hong Kong’s Monetary System The Official Float Policy An Indeterminate Exchange Rate? A Timely Depreciation Hong Kong’s Other Options Epilogue SIX ESSAYS IN PERSUASION Back to Basics on Budgets Confrontations over Deficits An Open Letter to the Brazilian Finance Minister Letter to Another Brazilian Finance Minister The Economics Are Simple 211 212 214 215 218 222 223 228 228 231 233 237 Credibility A Delicate Institutional Issue Advice Reasonable Doubt about the Real Plan An American History Lesson for Europe 241 245 MACROECONOMIC FEATURES OF THE FRENCH REVOLUTION 248 with Franỗois R Velde Introduction Chronology of Events 248 Before the Revolution Even Absolute Monarchies Have Budget Constraints 251 Macroeconomic Theories Coloring Our Observations The British Experience Across the Channel French Fiscal Backwardness or Optimality? Snapshot of the Old Regime Laws Offices Taxes Apology for the Old Regime Fiscal Pressures to Reform Sentiment for Copying Britain A Temptation Resisted Sustainability or Bad Choices? The Last Fiscal Crisis of the Old Regime The Search for a New Order Annus Mirabilis (1789) 267 Some Adverse and Persistent Revenue Shocks Designing a New Tax System Birth of a Currency Rise and Fall of the Assignat A Real-Bills Regime (1790–92) War Terror (1793–94) Legal Restrictions Hyperinflation (1795–96) 274 The Government’s Response Default The Legacy Unintended Consequences for England through Specie Flows Appendix: The Auction Mechanism 10 UNITED STATES THEN, EUROPE NOW Introduction The Math Need for More Economic Theory? 292 294 297 297 300 A Humbling Message? Modeling Reforms The United States Victorious but in Default 307 Trade Policies Crisis and a Second Revolution Restructuring Fiscal Institutions The Order of Fiscal and Monetary Reorganizations 310 Fiscal Policy Discrimination and Liquidity Federal Bailout of States Why Pay? Monetary Arrangements A National Bank? A Mint Outcomes Following Through? Federal and State Paper Monies? 319 What Kind of Fiscal Union? 323 What Kind of Currency Union? Author Index Adams, Henry C 324, 326 Aftalion, Florin 249 Aiyagari, S Rao 303, 316, 324 Alpert, Paul 118, 119, 123 Arellano, Cristina 304, 305 Arrow, Kenneth J 45 Auernheimer, Leonardo 281 Bagehot, Walter 322 Bailey, Martin 131 Bailleul, Jean-Antoine-Guillaume 281 Bancroft, George 321 Barro, Robert J 39, 111, 114, 126, 199, 208, 256, 316, 324 Bassetto, Marco 306, 312, 316 Battaglini, Marco 319 Beard, Charles A 310 Bien, David 258 Bilson, John 122 Blume, Lawrence 301 Bomberger, William A xix Bordo, Michael D 249, 293, 294 Borges, Jorge Luis 307 Bosher, John Francis 259, 294 Bouchary, Jean 281, 288 Bournisien, Charles 296 Braesch, Frédéric 277, 278 Bray, Margaret 301 Bresciani-Turroni, Costantino 42, 62, 171 Brewer, John 316 Brezis, Elise S 283 Brittan, Samuel 128 Brown, William Adams, Jr 117 Bruno, Michael xix Bryant, John 9, 29, 121, 134, 163, 276 Buiter, Willem 138, 141 Bulow, Jeremy 250, 261, 314 Cagan, Phillip 6, 23, 67, 135, 171, 180, 250, 276 Calvo, Guillermo A 32, 281 Caron, Pierre 279 Chari, V V xx, 250, 256, 261, 262, 306, 308, 314 Christiano, Lawrence J 256, 314 Clamageran, Jean-Jules 255 Coate, Stephen 319 Conklin, James 248, 263, 297 Cosell, Howard 17 Cournot, Augustin 308, 309 Crouzet, Franỗois M 283 David, Paul A 309 Debortoli, Davide 319 Dewey, Davis R 313, 316, 321 Dornbusch, Rudiger xix, 117, 138, 233, 234 Drazen, Allan xix Dupâquier, Jacques 270 Easley, David 301 Eaton, Jonathan 305 Eckstein, Otto 111 Elkins, Stanley 308 Fama, Eugene F 53, 67 Fetter, Frank W 292 Fischer, Stanley 114, 121 Fisher, Irving 297 Forbonnais, Franỗois Vộron de 263 Friedman, Milton 8, 29, 126, 165, 166, 173, 198, 199, 273, 297, 331 Fudenberg, Drew 306, 327 Garber, Peter M xix Gersovitz, Mark 305 Ghosh, Atish R 318 Graham, Frank D 60, 63, 64, 106 Granger, C W J 304 Greif, Avner 254 Grossman, Herschel 257 Haig, Robert Murray 118, 120 Hall, George J 308 Hall, Robert E 199, 208 Hamilton, Alexander 310, 312, 313 Hansen, Lars Peter 2, 12, 250, 297, 301–305 Harris, Seymour E 249 Harrison, J Michael 305 Hawtrey, Ralph G 144, 292 Heaton, John 304 Hicks, John R 254 Holtfrerich, Carl-Ludwig xix Howe, Daniel Walker 322 Huyck, John Van 257 Irwin, Douglas A 309, 311 Jagannathan, Ravi 305 Jones, Larry E 308, 314 Kareken, John H 46, 131, 141, 223, 327 Kehoe, Patrick J xx, 250, 256, 261, 262, 306, 314 Keynes, John Maynard 22, 45, 46, 49, 61, 66, 222, 233, 237, 276 Kim, Jun I 318 Klein, Paul 319 Kletzer, Kenneth M 314 Kreps, David M 301, 305, 327 Krishnamurthy, Arvind 316 Krusell, Per 319 Kurz, Mordecai 45 Kydland, Finn E 32, 202, 297, 319 League of Nations 43, 58, 60, 75, 82 Lee, Junghoon 304 Leijonhufvud, Axel 142, 291 Levine, David K 306 Litterman, Robert B Liviatan, Nissan xix, 31 Ljungqvist, Lars 330 Lucas, Robert E., Jr xviii, 1, 2, 11, 39, 46, 111, 114, 163, 202, 256, 297, 301, 303, 305, 314 Macaulay, Thomas B 254 Madison, James 319 Mailath, George 308 Makinen, Gail E xix Mallet, Jean Roland 263 Manuelli, Rodolfo E 250, 314 Marcet, Albert 301, 303, 316, 324 Marion, Marcel 249, 255, 296 Mathon de La Cour, Charles J 255 McCallum, Bennett T 27, 111, 127, 163, 174 McDonald, Forrest 309, 313 McKitrick, Eric 308 McPherson, James 323 Meltzer, Allan H 124, 126, 130, 315 Mendoza, Enrique G 318 Meredith, Don 17 Milgrom, Paul 254 Miller, Marcus 138, 141 Miller, Preston 163 Mitchell, Brian R 252, 253, 263 Moreau, Émile 144 Morgan Guaranty Trust Company 124 Muth, John F 297, 301 Necker, Jacques 255, 262, 264 Nichols, Donald 46, 49 Nicolas, Charles 270 North, Douglass C 240, 253, 316 Nunes, Ricardo 319 Ostry, Jonathan D 318 Paal, Beatrix 314 Pasvolsky, Leo 50, 51, 55, 66, 70, 73, 75, 81 Paxton, Robert O 60 Peled, Dan 31 Persson, Mats 281 Persson, Torsten 281 Phelps, Edmund S 112, 114 Poole, William 131 Postlewaite, Andrew 308 Prescott, Edward C 32, 202, 250, 297, 301, 319 Quah, Danny 193 Qureshi, Mahvash S 318 Rakove, Jack M 298, 309 Ramel de Nogaret, Dominique-Vincent 277, 278 Ratchford, Benjamin Ulysses 325 Reid, Constance 62 Richard, Scott F 305, 315 Riley, James C 255, 266 Ríos-Rull, José-Víctor 319 Roberds, William 250, 301, 302, 304 Rogers, Carol Ann 264 Rogers, James Harvey 118 Rogoff, Kenneth 250, 261, 314 Rolnick, Arthur J 323 Rossi, Peter E 314 Roussanov, Nikolai 304 Saidi, Nasser H 138 Samuelson, Paul 39 Samuelson, Paul A 64, 177 Sargent, Thomas J 1–3, 9, 12, 29, 39, 46, 47, 66, 116, 131, 135, 163, 172, 198, 199, 202, 208, 223, 250, 255, 273, 276, 291, 297, 301–304, 306, 308–310, 315–317, 322, 324, 330 Scarth, William M 163, 174 Schama, Simon 266 Schwartz, Anna Jacobson 297 Scott, William A 325 Seppala, Juha 303, 316, 324 Shaefer, Jeffrey 142 Shirer, William L 118, 121 Siklos, Pierre L xix Sims, Christopher A 2, 297, 304, 331 Singleton, Kenneth J 305 Smith, Adam 273, 280, 317, 322 Solar, Peter 309 Stokey, Nancy L xviii, xx, 202, 256, 297, 306, 314 Stourm, Robert 249 Sturzenegger, Federico xix Svensson, Lars E O 281 Sylla, Richard 311 Taylor, John B 112, 117, 144 Townsend, Robert M 39, 46 Velde, Franỗois R 264, 266, 294, 297, 310, 315 Villamil, Anne 276 Vissing-Jorgensen, Annette 316 Wallace, Neil 9, 29, 33, 39, 46, 47, 64, 66, 121, 131, 134, 135, 141, 163, 172, 198, 223, 250, 255, 273, 276, 306, 309, 317, 322, 327, 330 Wallis, John Joseph 326 Webb, Steven B xix Weber, Warren E 297, 323 Weingast, Barry R 240, 253, 254, 316, 326 Weir, David R 251, 252, 264, 266, 294 White, Eugene N 249, 266, 279, 293, 294 Wicker, Elmus R xix Wills, Gary 311 Wolf, Holger xix Wood, Gordon 308 Wright, Brian D 314 Wright, Robert E 311 Yeager, Leland B 115, 118, 119, 123 Young, John Parke 49, 53, 61–63, 71–74, 78, 81, 82, 87, 89, 90, 93–95, 105–110, 117 Subject Index actions isolated versus recurrent, 46 agent as a constrained optimization problem, 305 Allied blockade, 47 armistice of 1918, 58 assignat, 249 Austro-Hungarian Empire, 47 backing of currency guillotine, 248 land, 248, 250 legal restrictions, 250 taxes, 248, 250 backing of government debt seigniorage, 45 taxes, 28, 45 balanced budget, 57 Bismarck, Otto von, 239 Brazil, 228 Bremridge, Sir John, 226 Briand, Aristide, 144 Caisse d’Amortissement, 120 capital levy, 119 Carter, Jimmy, 113 Charles, King of Hungary, 54 Chartered Bank, 213 chicken game of, 33, 35, 145, 146, 204, 205, 233 Neil Wallace, 204 China, 226 Clegg Commission, 135, 136 commitment technology, 20 Constitutions US two of them, 297, 298 consumption function, 10 contingency, 19, 208 contingency plan, 17, 20 contracts overlapping, 112 Taylor model, 112 coordination monetary and fiscal policy, 18, 162 core inflation, 111 Cowles Commission, 11 credible policy, 239 diciphering, 239 Necker’s explanation, 262 Reaganomics, 33 Currency Board, 214 currency reform, 49 Dawes, Charles, 62, 63 debt management, 22, 163 decision rules, 1, 10–13, 113 default, 248, see also reform deficit capital account, 133 current account, 133 Devisenzentrale, 49 Directory, 249 dominance, 20, 36 fiscal versus monetary authorities, 36 dynamic game, 19–22 econometric model, 1, 2, 6, 10, 46 European Union, 298 Exchange Fund, 212–218, 221, 222, 224, 225 exchange rate depreciation, 218 determinacy, 215 Federal Reserve Board, 164, 232 Fisher effect, 128 football team, 17 France 1926, 23 hyperinflation in, 287 revolution, 248 free-rider problem, 299 game dynamic, 19 of chicken, 33, 35, 145, 146, 204, 205, 233 team, 19 timing protocol, 19, 307 Girondins, 249, 283 Gold standard, 42 government budget constraint intertemporal, 197 government deficit inflationary consequences, 6, 22 guillotine backed currency scheme, 249 wage and price controls, 249 Hamilton, Alexander, 245 Hapsburg monarchy, 53 Hegedus, Lorant finance minister in Hungary, 66 Herriot, Edouard Marie French prime minister, 119 Hilbert, David and units of measurement, 62, 241 Hong Kong 1997, 211 dollar, 213 Exchange Fund, 212 float policy, 214 Hong Kong and Shanghai Bank, 213 Horthy, Admiral Miklos, 54 Howe, Sir Geoffrey, 132 hyperinflation in Austria, 47 in France, 249, 276, 287 in Germany, 60, 236 in Hungary, 24, 53 in Poland, 58 not in Czechoslovakia, 64 investment decision, schedule, 3, 10 tax credit, investment decision, 203 irrelevance of some policies, 116 Jacobins, 249 k-percent rule, 127 Karolyi, Prince, 54 Kemp-Roth tax legislation, 202 Keynes, John Maynard, 45, 222 King Louis XVI, 248 Kun, Bela, 54 League of Nations, 43, 50, 56 Lucas Critique, 11 Maximum laws of, 284, see also wage and price controls Mexico 1982, 23 model as collection of constrained optimization problems, 305 momentum, 39, 111 monetarist arithmetic unpleasant, 198 monetarist models, 127, 166 monetary policy tight or easy, 163 Moreau, Émile, 144 Necker, Jacques, 239 neutrality, 116, see also irrelevance North Sea Oil, 136 Pareto inferior, 180 pattern imposition, 307, see also pattern recognition pattern recognition, 250, see also pattern imposition permanent income, 199 Phillips curve, 64, 112, 114, 115, 117, 140, 141, 228, 230 Poincaré, Raymond, 118 Poincaré miracle, 116, 143 Polish State Loan Bank, 58 quantity theory, 24, 52 Rasin, Dr Alois, 64 rational expectations, 2, 4, 15, 22, 25, 31, 39, 40, 47, 67, 111–116, 121, 123, 124, 126, 127, 129, 139, 173, 199 Reagan monetary and fiscal policies, 197 Reaganomics, 33 real interest rates high, 198 Real plan, 241 reconstruction loan, 56 reform, 248, 307, see also default regime, 46 Bryant-Wallace, 29 debt servicing, 9, 31 Ricardian, 8, 27, 33, 36 Reichsbank, 60 Rentenbank, 62 Rentenmark, 62 Reparation Commission, 236 claims on Hungary, 55 Reparation payments Germany and Brazil, 236 Reparations Commission, 47, 51, 56, 118 reputations costly to acquire, 299 sustaining distinct ones with different people, 299 rules of the game, 1, Rumania, 54, 56 Russia, 28, 58, 61 seigniorage, 162 self-confirming equilibrium, 306 simultaneous equations econometrics, 10 speculation, 211 stabilization in Austria, 52 in France, 119, 291 in Germany, 62 in Hungary, 56 in Italy, 117 in Poland, 58 Stackelberg timing protocol, 20 Stigler, George, 197 strategic interdependence, xxii, 20 structural parameter, 10 tax smoothing, 199 terror in France, 283 red, 54 white, 54 Thatcher, Margaret, 111, 232 time consistency, 32, 202 Treaty of Saint-Germain, 48, 54, 65 of Trianon, 54, 55 of Versailles, 118 value added tax (VAT), 125 Volpi, Count, 117 wage and price controls and guillotine, 249 in Brazil, 233 in the UK, 115 Walters, Alan, 145 waltz of the portfolios, 23, 119 Washington, George, 245 .. .Rational Expectations and Inflation Rational Expectations and Inflation Third Edition Thomas J Sargent Princeton University Press Princeton and Oxford Copyright © 2013... Addison, and Ari Contents LIST OF FIGURES LIST OF TABLES ACKNOWLEDGEMENTS PREFACE TO THE THIRD EDITION xi xiii xv xvii PREFACE TO THE SECOND EDITION xix PREFACE TO THE FIRST EDITION xxi RATIONAL EXPECTATIONS. .. taxing and spending authorities This idea will guide our interpretation of the causes of the beginnings and endings of inflationary episodes The first chapter, Rational Expectations and the