bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

218 MONETARY ECONOMICS
output all remain unchanged. The level of unemployment does not fall.
Thus, fully anticipated changes in monetary policy are ineffective in influencing
the level of output and employment even in the short run. This is
known as the policy ineffectiveness or policy irrelevance theorem.
According to this theorem, the only way in which the authorities can
influence output and employment through demand policies is to take market
agents by surprise. For example, an unexpected increase in the money
supply causes workers and firms to see the consequent increase in the general
price level as an increase in relative prices. They react by increasing
the supply of output and labour and the economy moves to a new short-run
aggregate supply curve. Both employment and output temporarily increase.
As in the expectations-augmented Phillips curve, once agents realize there
has been no change in relative prices, output and employment return to their
natural levels at the higher price level. However, there are two important
differences from the expectations-augmented Phillips curve.
Firstly, market agents include the rate of money supply growth in the
information they use to forecast inflation and quickly realize that inflation
is about to rise. They thus adjust their inflation forecasts much more quickly
than in the expectations-augmented Phillips curve case, where agents do
not realize what is happening until inflation actually rises.
Secondly, the authorities are unable to exploit the possibility of the temporary
trade-off between inflation and unemployment. If they try to reduce
unemployment through monetary shocks at all frequently, agents learn that
this is what the authorities do when unemployment reaches undesirable levels.
Workers and firms anticipate the monetary shocks and are no longer
taken by surprise. In other words, any short-run trade-off between inflation
and unemployment disappears if the authorities try to exploit it.
The more often the authorities try to engineer reductions in unemployment
through monetary shocks, the less easily are workers and firms fooled
and the more vertical is the short-run Phillips curve. The incorporation of
government into the model ensures the policy invariance result. If market
agents believe that increases in the rate of growth of the money supply have
no real effects but only cause increases in the rate of inflation, government
cannot have an impact on output and employment by increasing the rate of
growth of the money supply. When governments do this, market agents
immediately respond by raising their inflationary expectations, the short-run
Phillips curve moves out and the economy remains at the NAIRU. Money
is once again neutral.