By Tanveer Ahmad Khan
Appropriate policy that hits macroeconomic targets perfectly has remained the bone of contention among various economists since the birth of subject. Macroeconomic effects of policy actions have produced diverse results at different points of time. A policy that remained effective at one point proved to be ineffective at another. The policy framing about the economy has always been subject to disagreement. There are always policy crosscurrents in the economics profession. Proponents of different economic thoughts will offer different solutions to the same problem: one group may call for lowering taxes to stimulate Aggregate Demand and another group may call for increase in money supply. But question remains why they are at policy discards? The solution lies in understanding the problem faced by economists in modeling the economy.
People expect economists to be correct about their forecasts. But, they know little about the fact that inconsistencies have ensnared economists. The behavior of economic agents (firms and consumers) is very difficult to predict. The conflicting tendencies produced by the occasional irrational behavior of agents have made the economic theories susceptible to generic failure. The 2008 Global Financial Crisis is the worst economic debacle of the century. Many would ask why economists have not predicted such a humongous financial crisis.
The Great Depression of the 1930’s produced special interest in economics profession. It marked the birth of macroeconomics. Macroeconomists tried to deal with macro problems confronting the economy. Early Macro-economists offered solutions without a micro foundation that would justify their actions. They offered solutions which seem to be palatable to the imposing situations of the time. With the growth of subject, economists tried to model the economy in a way that seemed to address the policy issue. Models basically dissect and simplify the complex system of interactions. A given model is based on certain assumptions about the particular phenomenon under consideration. These assumptions about economic agents when viewed in reality seem to be specious. The predictions based on these models will definitely lead to erroneous conclusions and outcomes.
The most important assumption that often renders them to serious chastisement is that of Certainty. Since future is always uncertain. We can’t predict it with 100% accuracy. Major models which describe the behavior and structure of economy are based on the certainty assumption. The conclusions therefore derived should not be taken as gospel truths. Economists deal with human beings. And, human behavior is quite unpredictable. Although natural sciences have found increased application in economics in recent years especially mathematics but it still remains under the grip of uncertainty. Uncertainty about economic variables like future expectations of people, future interest rates, future prices, stock markets and future incomes render economists helpless. The macroeconomic structure of an economy is very diverse and complex and to model it is not a cakewalk for the economists.
However, economists solved this conundrum by making the use of expectations about future uncertain variables. The expectations about future have greatly helped the economists to lessen their constraints. But, the puzzle that again remained was how expectations are itself formed. Different schools of economics [Like Classical School, Keynesian School, Monetarists, New Classical and so on] differ regarding how expectations are formed. The classical school believed in Perfect Foresight of economic agents. So there is no uncertainty and no role of expectations. Keynesian’s expectations are regressive that is economic agents expect that economic variables will return to their normal level after disturbance. Monetarists led by Milton Friedman put forward the Adaptive Expectation Hypothesis according to which economic agents base their expectations on the basis of past and present information and most importantly they learn from their mistakes.
The new Classical economists believed in the Rational Expectation Hypothesis. According to this school rational “rational agents make the use of all relevant information optimally and efficiently and they make no systematic error” s. The most important result of the New Classicals was that Monetary and Fiscal policy has no role in dealing with macroeconomic disturbances and economy had a natural tendency to return back to equilibrium. This came to be known as ‘Policy Irrelevance Theorem’. Thus, there is natural tendency that these schools may differ in solutions they offer to almost same economic problems. Our forecasts are greatly affected by the way we make assumptions about how expectations are formed.
This is the one simple puzzle economists’ face. There are many more of them which make economics profession a risky vocation. Another may be how to deal with different tradeoffs like inflation and unemployment, growth and environment, leisure and work and so on. Bringing an optimal synergy among conflicting tendencies is not an easy task. The best way forward will be to make forecasts and predictions but at the same time warn the parties that a forecast is nothing but an educated guess. It may be true most of the times but not at all times. With this caveat, economists should proceed forward and make the use of scientific methods which will allow them to hit the target with maximum probability.
The author is pursuing his Master’s degree in Economics. He can be reached at: firstname.lastname@example.org