This paper is based on a long-term research program with Rachel Kranton on the implications of identity

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view that consumers think that the price of the item should not change (for whatever reason) and

are likely to retaliate (change brands) if it does.

Summary 

In sum there is a significant body of evidence that suggests violation of both the

assumptions and the predicted outcomes of natural rate theory.  Relative to natural rate theory,

this evidence suggests excess sensitivity to nominal concerns.  Employee and customer views

regarding what wages and prices should be will explain these anomalies.  In turn this yields a

theory that is remarkably close to the old-style Keynesian story: even though wage setters and

price setters do take account of inflationary expectations, there will still be long-run trade-offs

between inflation and unemployment.  Once again notions regarding what should or should not

be, and their inclusion in utility functions, negates an important neutrality result—that there is no

unique sustainable level of unemployment without steadily increasing or steadily decreasing

inflation.  

 

VIII. Rational Expectations Theory

Our discussion of rational expectations will piggy-back on our previous discussion of the

natural rate.  

According to rational expectations theory, insofar as the Central Bank changes the money

supply systematically in response to employment conditions, the public will foresee that

response and change prices and wages exactly to compensate.  The public’s anticipation will

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Empirically there is a theoretical puzzle of excess sensitivity to monetary shocks (Christiano,

Eichenbaum, and Evans (1998)).  Christina and David Romer (1989) have shown that such a response occurs with

lags that would be surprisingly long if expected monetary shocks were always neutralized.  

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then exactly offset the response.  Monetary policy is neutral.

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There are two key assumptions underlying this neutrality.  The obvious one is rational

expectations.  To some rational expectations regarding the effects of the money supply on prices

and wages would seem to be beyond the scope of most wage and price takers, as well perhaps as

beyond the economic knowledge of most wage and price setters. 

But, even in the case where all those involved in buying and selling goods and labor

services have rational expectations, the neutrality results of rational expectations theory require

also that nominal considerations do not enter into the setting of either wages or prices.  The

previous descriptions of the ways in which nominal wages and prices enter into preference

functions via employees’ views of the wages that ought to be received and consumers’ views of

the prices that ought to be paid, give further reason why the neutrality results of rational

expectations will be violated.  If prices and wages are affected by people’s notions of what their

nominal values should be, changes in the money supply will have an effect on real output and

employment.   Monetary policy can be effective in stabilizing output, and perhaps even in raising

its long run level even in the presence of rational expectations.  

IX.  Economic Methodology

We have seen that the absence of norms plays a key role in each of the five neutralities. 

Their omission from macroeconomics, and also economics more generally, can be explained by

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Some of the thoughts and wording in this section have been presented in Akerlof (2005).

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the nature of standard positive-economics methodology.

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  Following Friedman’s (1953) essay,

“The Methodology of Positive Economics,” economic theorists should strive for parsimonious

modeling.  Indeed, according to Friedman, they should even forsake realistic assumptions in

pursuit of such parsimony.  Maximization models with only objective arguments of utility are

more parsimonious than models where people, additionally, lose utility insofar as they, or others,

fail to live up to their standards.  As a result, whatever the empirical validity or relevance of such

norms, positive economics has a methodological bias against their consideration.  

The prescriptions of positive economics regarding the conduct of empirical investigation

compound the bias against norms.  Friedman says that economists should not pay heed to the

stated intentions of decision makers, which would especially include their norms as to how they

should behave.  Instead, empirical work should only test hypotheses suggested by economists’

parsimonious models of behavior.  In contrast, a more naturalistic approach would prescribe a

very different methodology.  In this case economists would observe decision makers as closely

as possible, with the express intent of characterizing their motivation, and would use such

characterization as the basis for modeling of economic structure.  Indeed sociological and

anthropological ethnographers do precisely that: they depict their subjects’ motivation from

close observation. 

If economic tests had great power, then it would be easy, of course, to follow Friedman’s

dictum of making more and more refined tests of hypotheses with decreasing parsimony.  With

such power, in due course, this method would get to models where people’s views regarding how

they should behave affect decision-making, if that is how people really do operate.  But even the

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