SHOULD

CONTROL

THEORY

FOR ECONOMIC
Edward

C. Prescott

Carnegie-Mellon
In a genetic-historical
in outlook

view

which

natural

science

nature

are

exhortation,

of the

like

which

deception,

characteristically
that

men

must

that

i.e.,

the inert

subject

since

drawn

natural

be like natural

objects

to

of

persuasion,

etc., but are inexorable.

we have to combat

an inference,
race,

revolution
of modem

men,

of

our

fundamental

the real beginning

was the discovery

coercion,

The position

University

represents

not

BE USED

STABILIZATION?*

seems to rest upon

by the

objects

objects

best

are not

(Knight,

minds

like men,

1941, p. 121).

I. INTRODUCTION
Modern
management

control

trajectories

with

significant

efficiency

It has become
economic
Many

if not most

There

have been

Currently,
Governors
techniques
simplified
tradition

gains

a useful

manned

reduced

takes

be used to improve
in the profession
numerous

models
of

the

to

the

studies

can

Kalchbrenner

version

over time.

scheduling

be

and Tinsley

Federal

Reserve

design

of macro

of

the

Fed-MIT

at its best and was designed

It has made possible

that naturally
of a market

the answer

when

arises is,
economy?

to this question

have demonstrated

effectively

control.

and firm behavior

The question

believe

more

individual

and

by finding

and inventory

the performance

which

engineering

on the moon

fuel requirements.

in production

place

tool in both

landings

the basic tool used to describe

theory

econometric

has become

It made possible

dramatically

activity

can control

theory

science.

is yes.

convincingly

controlled

through

that

its

use.

(1975),

staff

members

of the Board

System,

are

applying

optimal

stabilization
model,
specifically

which

policy.
reflects

for policy

of

control

They

are using

the

econometric

evaluation.

Revised January 1977. I would like to acknowledge valuable discussions with several of my colleagues,
in particular Allan Meltzer and Robert Townsend. TIE. views presented are my own.
1

See Kendrick (1976) for a survey of cwr ninety such applications.

13

Ill fd,
in actual
economy

decisions
way

informal

what

has been used in an informal

have looked

to evaluate

employment,

selection,

at the current

of

Given that control

better

considered

as Kalchbrenncr

the consequences

and prices.

it is surely

is generally

waq

state of tile

that it be applied

to bc the brst

and Tinsley

in

econometric

advocate,

than in the

way it has and is being used.

(1953)

economctricians
predicts

they

efforts

do.

of

and magnitude

fine tuning

the

contributing

Federal

growth

in the money
theory

invariant
models

economy

not

of monetary

have

and that

He has argued
and tested

be attempted.

rules is preferable

the

attack

economy

of the econometric

of

a detailed

System

instability,

fundamental

to stabilize

use

of caution.

having

policy

He argues

had

the

a neutral

that

and that.

that

thr

perverse
policy

that

theory

best

effect

of

of a constant

to the use of macro models

and

methods.

A more
structure

should

supply

a note

of the effects

Reserve

to economic

control
theory

has sounded

are a long way from

the timing

macro

theory

law of motion

output,

evaluation,

Friedman

the

upon

using

for policy

model

not

control

Policymakers

is being used for policy

a formal

until

time,

Some

selection.

and used an implicit

alternative
theory

for

policy

upon

model

describing

to the policy

rule.

are worthless

in assessing

economic

under

theory

alternative

the best operating

the LW of macro

models

is due to Lucas (1 976).

and that

the

that

policy

using

is

the major

rules. He advocates

operatin, 0 characteristics

rules and the selection

the

of the economy

simulations

alternative

to predict

policy

the motion

policy

and control

Hc argues

of the

of a rule which yields

characteristics.

In commenting
on Lucass essay, Gordon (1976) has suggested that if
changes in policy change the law of motion (i.e.. structure
of the econometric
model)
only

in a predictable
take

(1977)

into

attempt

dynamic
games

continuation

nature.

is inappropriate
At this

point

fluctuations

economy

be better

and optimal
evaluate

that

the

control

alternative

the rational

I would

can still be
policy.

policy

One need
and I

Kydland

impossible.

Even in

is inconsistent.

in subsequent

periods

plan over the reniainder

expectations

used.

equilibrium

Unlike

is not

the

of the planning

paradigm,

optimal

selection.

like to emphasize

can or should

that

the issue is not whether

be rcducCd. The question

stabilized

through

theory

or through

stabilization

optimal
plan

optimal

for policy

theory

in designing

and find it logically

the

optimal

of the first period

economic

control

situations,

If one accepts

control

then

such changes

to do precisely

deterministic
against

horizon.

way,

consideration

the use of econometric

the

LIX

of dynamic

rules? Given the enonnoux

14

is, rather.

can the

simulation
economic

models
theory

costs associated

to

with

unsuccessful
tation

macro

to resolve

been

performed

model

to

policy,

it seems

this debate.
are neither

simulate

the

application

economy,

invariant

to the way policy

analyses

tests of the alternative

or self-fulfilling

expectations

Control

theory

being

expository
current

time

Neither

experimen-

and tests

They

a fixed

law of motion

are my and Kydlands

paradigms,

that have

all use an econometric

assuming

OF STOCHASTIC

presupposes

the

In discrete

and because

class-next

position

nor test.

scientific

to consider

as in both

nor Lucass

cases a rational

world is assumed.

controlled.

simplicity

the discrete

ludicrous
applications

thereby

is selected.

II. A REVIEW

system

almost

The so-called

existence

THEORY

of a law of motion

time--which

virtually

periods

xt. the action

CONTROL

will be

all quantitative

position

or state

of the controller

for the

assumed

macro

xt+l

here

models

depends

for

are in

upon

ut, and an independent

the

shock

e t; that is,

xt+]

(1)

= F(xt>ut. Et)

In a macroeconomic

application,

an econometric

model.

for most

models,

macro

and certain
used

obvious

to translate

a first-order
The
Tinbergen

of

on the

or if there

and an objective
developed

was linear,

methods
production
advocated

difference

were

with

These

desired
function

scheduling

applied

instruments

must

and

errors,

form of

as is the case

these lagged variables

procedure

with a single variable

demand

management

a set of target variables

path.

computationally
first

one,

into

n variables.

If there

are costs of adjusting

with additive

include

equation

aggregate

in whose scheme

are selected.

variable

than

added to F. This is just the well-known

order

quantitative

variables

(1957)

nth

father

instruments,
offs,

must

equation

of instruments
target

the state

difference
(1956),

F would be the reduced

of lags is greater

identities

an

the function

If the order

are adjusted
are more

and the objective

(Holt,
inventory

Modigliani,
control.

that they be used for macroeconomic

15

there

Simon

techniques

when
function

Muth,

and

Subsequently,
planning.

is

so as to keep the

target

instruments,

be introduced.

feasible

policy

and an equal number

variables

than

will be trade-

(1956)

and Theil

the law of motion

quadratic.
Simon,
Theil

These

1960)

to

(1964)

If the
Taylor
quadratic

of motion

law

series

expansions

functions

relevant
systems

are used

then, before

to form

to approximate

the objective

optimally

these

whether

and magnitude

of the effects

uncertainty,

attempts

at

of contributing

analogue

When

are ill understood

(for example,

best

control

is not

practice

and only when

science

physical

to attempt

fine

argument
systems

the

perverse

has

a direct

with

transients

steel making

tuning.

moves

in the timing
given this great

to have

This

some continuous

the process

over the
stochastic

or engineering.

and that,

arc likely

instability.

controlling

that

infrequently

supply,

stabilization

economic

function

is great uncertainty

of the money

active

to

in engineering.

that there

Similarly,

used to control

arise in management

has argued

these techniques,

approximations.

This is the basic method

(1953)

applying

linear

range of outcomes.
Friedman

effect

is nonlinear,
are used

processes),

Adjustments

arc made

out of some acceptable

control

range.
Builders
deduce

the

of macro
fonn

of

econometric

relationships

The nature

of the adjustment

empirically

by starching

which

provides

Silverman
models,

the

Unlike

probability

model

Chow
worked

errors

of this
found
if the

the Wharton
data,

model

suggesting

the

type.
Wharton

well when

Wharton

for the one

McCuire,

model

may

and

econometric

process

is high.

robustness

policy

model

hand,

stocks.

has not been shown

The only

that optimal

On the other

performed

adjustment
theory

to

is determined

sizes used in estimating

an incorrect

( 1976),2
poorly

stock

lag relationships

of control

theory

or stationary

work by Geiscl.

for sample

a lack of robustness.

desired

to the desired

econometric

of selecting

to specification

suggesting
from

that,

economic

of distributed

the performance

I am aware,

Michigan

the

indicates

forecasting,

be robust
which

a space

static

LISP

detennining

of the actual

the best fit. Recent

(1975)

models

study

derived

the Michigan
be more

the

policy
model

robust

of

from the

generated

the optimal

to

data,

derived

generated
for control

purposes.
If the
theory

can

specifying
the

decision

2John

programming
facing

the expected

is augmented
unknown

in the

be effectively

the law of motion

the dynamic
maximize

uncertainty
still

brought

law of motion
The

of Bellman

controller

is well

value of some criterion

specifying

there is a well-defined

this work

to my attention.

16

is moderate,

uncertainty

is represented

methods

by a set of variables

parameters,

B. Taylor

the

systems
applied.

in the

by a prior distribution.
(1957)

defined,

and Blackwell
the

function.

objective

Using
(1965).
being

to

When the state variable

the controllers
law of motion.

control

parameters

distribution

on the

Practical
engineering
assume

methods

and

functions

objective

are based

are independent

quadratic,

and

selecting

coefficients.

determining

next

the

This
decision
observing

the result,

in dealing
uncertainty

found

profile

is not necessarily
control

have

state

decision

of state variables.

This

current

prior

the prior is updated

indicate

before

this procedure

worked

been

many

of the population,
inapplicable.

to structures

with

control

subject

accepts

the view that the economy

motion

and if one has sufficient

question

that modern

control

coefficients.

selection

to a policy
is governed
knowledge

theory

well

Wallace,

in policy,

as the demo-

optimal

Zellner

control
adaptive

(1971),

and

problem.

is an increasingly
invariant

and

the changing

such

(1973) have extended

Similarly,

when

relationships

Provided

factors,

into the control

theory

and more

1975).

Rolnick,

unstable.

and

way (e.g., MacRae,

in finding

Muench,

and not by changes

varying

optimal

systems

very successful

exogenous

of

has been made

perform

(see PJorman,

model,

effect

is obtained,
progress

however,

Sarris and Athans

model

expected

in a practical

of the relationships
changing

the

By using an instrument

of its effect

developed,

not

by slowly

have incorporated

for controlling

optimal

which would be optimal

Some modest

element

procedures

To summarize,

estimate

in the future.

Even for the Fed-MIT

is caused

value

in the

the controllers

ignores

is great, and the gains seem modest

Weiler (1974)

others,

from

Tests

however,

experimental

the

over time.

computing

of the coefficients.

a more precise

Econometricians

structure

draws

unknown

programming

are linear

with hundreds

decision.

knowledge

this
of

coefficients,

After each observation,

is possible

with

None

rules

with

If the coefficients

the dynamic

decision

systems

procedure,

future

control

of motion

observations.

was moderate.

decision

upon

effective

law

and

decisions. 3 The methods

at each stage that decision

periods

well when uncertainty

graphic

a linear

were independent

on the unknown

in the economics

optimal

following

optimal

even for complex

suggests

if the coefficients

stable

and

on the

Thus, as for the case of known

observation

independently

draws from some distribution,

are

rules is feasible

1972).

developed

to find approximately

a quadratic

coefficients

variable.

were

literatures

powerful

law of motion.

by some policy

invariant

of this law of motion,

there

tool
If one
law of
is no

should be used for macro planning.

In the economics literature,, I first used these methods in 1967; I was unable to determine when they first
the engineeringhterature. For further details on the methods, see Chow (1975, ch. 11).

appeared in

17

III.

DOES A POLICY

Many
that

social

constructs

years

ago Knight

problems

could

which

This warning
the

have produced
that

arguing

dynamic

that

economic

what happens,
knowledge,

and the models.

which are inconsistent

If it is not,
an underlying
rejected.

invariant

the basic

considerations

result

As before.

depends

in addition

sciences.

Lucas (1976)

attacked

with

or structural

everything

where

now

economic

relationship
known

actors

agents

as having

about

care

of the models,

about

are public

expectations

of the model?
of control

theory

to the way policy

in the

following

the actions

that

there

is selected
reformulation

there is a law of motion,

upon

the

of the natural

assumption

invariant

to assume
sciences

triumphs

Lucas asks, to model

problem.

state variable

to the social

or even the predictions

law of motion

Such

it was a fallacy

behavioral

with the predictions

then

EXIST?

More recently,

In situations

is it reasonable,

stabilization

the celebrated

inconsistent

theory.

that

by applying

unheeded.

a policy
it was

LAW OF MOTION

(194 1) argued

be solved

has gone largely

assumption

exists,

INVARIANT

be

of

the

but the motion

dt of the private

is

must

of the

economic

agents:

= F(xt+dt.

(2)

xt+l

Given

a policy

also possible)

et).

rule (here
which

assumed

specifies

deterministic,

but randomized

the values of the control

as a function

strategies

are

of the state

variable,

(3)

and

ut = p(xt)

relation

private

(2),

the

determination

agents is. like all competitive

If the structure

of preference

of the

is recursive,

of the form:
(4)

equilibrium

equilibrium

dt = 6,(x,)

18

these

analyses,

decision

rules of the

a fixed point problem.

rules will be time invariant

and

The

corresponds

6,

are indexed

law of motion

under

71 which

policy

to the behavioral

by the policy

In his critique

policy

yields

of current

equations

rule. Equations
rule

of econometric

models,

(2), (3), and (4) define

?T. The policy

desirable

operating

econometric

policy

design

problem

characteristics
evaluation,

but

the systems
is to find a

for the economy.

Lucas (1976)

advocates

this approach.
In commenting
in the policy
control
these
just

theory

period

changes.

and found

situation

and

a correct

position,

predict

situation,
functions

agents

to predict

theory

to rationalize

changes

that

choice,

they

do,

results

as indicated

to do

and the end of

strategies

policy.
policy.

which

in searching

that

policy

case the only plausible

use utility
of empirical

induced

a static

for the

that

one

for an optimal

only

framework,

static

optimal

tax policy

taxation

may strictly

consider

only

non-

This leads inescapably

alternative

player

and

with the fundamental

need

policy.

solutions,

solution.

the reaction

being small, behave

by

is selected,

is a game if agents maximize

arc many

one is the dominant

agents,

in

a randomized

takes into consideration

while the many

in behavior

This is at variance

selection

use utility

agents

policy.

Even

specify

there

private

say, a set of tax rates,

that

advisers)

and uses them to

There is a wealth

out

A policy,

the

With gaming problems,

the policymaker

carried

his economic

If policymakers

choice?

of future

has shown

theory

to the conclusion
policy.

way, then

attempted

choice

that

by changes

are

given

(1976)

control

randomized

if changes

given the current

outcomes

(actually,

not assume

social

the best deterministic

of

action,

individual

environments.

why

a problem.

maximize
Stiglitz

dominate

and I (1977)

current

rationalize

in new
then

analyses

are not

agents

problem,

that,

takes into consideration

The best

the policymaker

and predict

policy

expectations

Kydland

of both

in the publics expectations

Most

and

above,

which

choice

theory
evidence

suggests

in a predictable

the controller

impossible.

evaluation

(1976)

equations

is not optimal.

utility
the

As noted
it logically

In a dynamic
constructs

Gordon

the behavioral

can still be used, provided

induced
that

on this critique,

rule change

for given
but in this

In selecting

of agents

noncooperatively

policy,

to his decision,

and maximize

for

given policy.
The applicability
to a spirited
problem
empirically
behavior
expectations

debate

facing

of the hypothesis

agents

determined
than

can

of rationality

as to its plausibility.
in

dynamic

uncertain

disequilibrium
rational

equilibrium

There

19

rules

equilibria?
are,

1 think,

has led

of the forecasting

environments

behavioral

expectations

obtained?

of expectations

Is the complexity

so

can
How

great

better
is

answers

that

predict
rational
to

these

questions.
being

Competitive

obtained

economic

even

if the

introduce

an assumption

indicators

of expectations,

anticipations.
casts

Given

are sought.

about

how

economic

obtained,

there

future

policy,

behavior.

Unless

is unlikely

policy

in an equilibrium
Forecasters

will be selected

of consumers

the

rational

in the competitive

the same reason that the stock market

and sales

the

best

fore-

expectations

expectations

anticipations

both

and observe

confidence

anticipations,

the basis for peoples

between

to exist

result

understood.

plans, and

form

will be a discrepancy

a discrepancy

will likely

is not

such as measures

expected

But, the forecasts

aggregate

much

forecasting
structure

of

solution

and forecasts.

forecasting

is

Such

business

is efficient--profitable

for

opportunities

would exist.
Consistent

policy

A consistent
which

specifies

time.

The

elements.
motion,

policy

rules
For

finite

fundamental
games,
(1976)

optimal

policv
Given

resulted

control

question
takes
patent
realizes

that

should

into

with

of the world

at that

given the subsequent

Blackwell

has demonstrated
policies

invariant

policy

to infinite

the

period,

a policy

and any optimal

established

time

For

(1965) has extended

horizon
that

problems,

a consistent

are not necessarily

same

law of

is consistent.

result

when

For
policy

consistent.

he found

the

was inconsistent.

resources
products

protection

optimal

the state

problems

theory

for each

is optimal

and discounting,

(1975)

one

examule

in new

patent

policy

each

and that optimal

independently

monetary

Patent

decision

of control

Kydland
optimal

upon

that

is optimal.

returns

result

is not generally
Calvo

period
policy

of rules,

contingent

the property

with bounded

dynamic

is a sequence

action

have

a consistent

problems
this

policy

have

for existing
theory

consideration

monopoly

effects of alternative
selected.

allocated
the

inventions.

solution

be posed

protection

been

or processes.

of the

the incentive

and the loss in consumer

rent.

In other

policy

words,

policy

No one would

to be reasonable.

in terms

both

to inventive

efficient

Most

optimal

economic

consider

would

agree that

life policy,
activity

that results
theory

this
the

which

provided

when

by

someone

is used to predict

rules and a rule with good operating

20

which

to permit

seriously

patent

for inventive
surplus

activity
is not

the

characteristics

Dynamic

taxation

In recent
policy

example
years,

is optimal

constraint

that

a large optimal

if it maximizes
agents

supply

taxation

some

labor

literature

social

welfare

optimally

has developed.4
criterion,

A tax

subject

to the

given tax and wage rates.

The

optimal taxation literature has abstracted

from the savings decision and focuses
only on labor supply and consumption.
Once the time dimension is introduced,
optimal

taxation

principle

of

policy,

consumption

decisions

Suppose

there

the (expected)
is the
behavior

depend

tax

rates

income

In subsequent

on labor

is zero

future

maximizes

in the

both

optimal

current

become

given

tax policy

of this consumer,
and the

Assuming

are not

labor

period

and

that must be financed,

expenditures

and capital

solution

the current

utility

The optimal

will be taxed in the initial period,

periods,

The

supply

who maximizes
the welfare

expenditures

of the

periods

consumer

labor

tax rates.

and labor incomes.

which

is not consistent.

current

future

given the tax policy,

The inconsistency

eventually

because

upon expected

of government

of the consumer,

inelastically.

or deterministic,

hold

on capital

of tax

stream

random
not

is a representative

too large, only capital

taxed.

does

tax rates

sequence

given some

whether

optimality

as it is supplied
incomes

arises because

and positive

will be

the optimal

in future

ones,

but

one.

Other examples
The

inconsistency

problem

provides

the

rationale

contracts
and for certain legal principles
such as grandfather
policy debates, however, the principle is ignored, for example,
crop
the

shortfall,
products

the government
future

price,

controls
or when

current
the

for

price promising

government

enforceable

clauses. In many
when, following a

imposes

not to control
rent

controls

on existing rental units but not on new units. Similarly, no rational private
agent would stockpile
oil speculating
on another embargo because he would
realize that, in such an event, the government
would almost surely again control
the price of oil.

Use of control
Control
scheduling
which

theory

in management

theory

production>

equates

from physical

next

has

proved

The reason

periods

considerations

stock

science
useful

in

controlling

it has succeeded
to current

and is invariant

inventory

stocks plus net additions

to policy selection.

4See t&nsey (1927), Diamond and Mirrlees (1971), and Stigtitz and Dasgupta (1971).

21

and

in

is that the law of motion

is derived

If the problem

is modified

to make price a decision

appropriate,
price

to tile extent

but on anticipated

monopoly
pricing

power

current

future

prices.

rely on a pricing

The

tenn

that

in control

control

and monitoring
in terms
clearly

control
not

is no longer

only

why

and do not

recognize

control

operating

that the policy

of alternative
theory

policy
the

should

on current

firms with some

use control

theory

for

economy

of dynamic

nearly

controllers

want to go in different

suggestion

monetary

wage contracts.6
which

is not

to guiding

has

Activist

been

If,

characteristics

of the economy

Let

supply

the

rule.

n=770-771

Cyert and D&root

an

to predict

theory
The

inert

rocket

is that

problem
rocket

ship when

of
ship.

the two

taken

I~XPICTATIOIVS

if expectations
enter

the

are rational,

into long-term

to mean

wage, is a mistake,

hand,
may

even

if agents

policy,

argument

nominal

the monetary

action

as the example

below

is that

the

operating

for some -rule other

rule, then there is no disagreement.
w maximizes

be superior

wage, and assume

the expected

to supply

log of labor demand

(w-p)+

planning.

to guiding

that,

nominal

other

given he is committed

wage. The assumed

is judged

Accountants

theory

equilibrium

AND RATIONAL

be the log of the nominal

given the policy

firm.

equilibrium

a dual-control
5

made

monetary

demonstrates.
money

on

is a set of rules
system

directions.

is appropriate

is best given the current

constant

analogous

CONTRACTS

policy

of the

USE

for economic

but more

The

is to

be used

the

activist

characteristics

problem

system

of a particular

rules.

stabilizing

analogous

but its USC is very different

control

implication

not

IV. LONG-TERM

in accounting,

An accounting
The effectiveness

resulting

To summarize,

6See

optimal
depends

This is probably

policy

is used

theory.

procedures.

of the

the effect

(5)

then

drmand

decisions.

from

worker,

variable,

that

utility

all the labor

it is set efficiently

of the representative
the firm wants

n is

e,

(1977) consider such a dual-controller problem.

Fischer (1977), Modigliani(1977), Phelps and Taylor (1977), and Taylor (1976).

22

than the

at that

where
p

e is an aggregate

is the

function

demand

log of the price

or supply

level.

for the individual,

and

shock and has mean zero, and where

Letting

u(. , .) be the appropriate

E the expectations

operator,

objective

the

w selected

is the one which maximizes

(6)

Ep n[u(w-P.n)l,

subject

to

(5).

approximated

u(w-pn)

(7)

Substituting

(8)

It

is further

by the quadratic

assumed

that

the

objective

function

can

be

function:

= w~(~-P) + (n - F 1I2

for n and taking the expectations

I-(~(w-P') +

Differentiating

[v. - v 1 (w-pe)

with

respect

to

- P

yields

1I 2 + var (E) +

w, setting

zero, and solving for w, the nominal

the

wage selected

v;var

resulting

(PI +

2771

expression

COV(C,P).

equal

to

is

w = pe + (7)o - ~1-/421)1)/77]

(9)

Without

knowledge

basis for forming

Control

theory

of the

way in which

policy

will be selected,

is no

price expectations.
or discretionary

With this solution,

solution

the rate of inflation

that will be selected

to be best relative

to some social objective

function

demand

(5),

the

function

representative

there

worker

and

the

value

and a democratic

function

and the workers

answers,

including

utility

the observation

of

society,

function

differ?

s(n,p),

realized

23

shock.

why should
Phelps

that labor income

given

can be said
w, the labor
If there

is a

the social objective

(1972)

is subject

provides
to income

some
tax,

which
for

will result

in an oversubstitution

market-produced

wedge

between

optimal

the private

(10)

using

of home-produced

goods

unemployment

insurance

addition,

and social

quadratic

s(n,p) = (n-02)

Another

question

objective

product

and leisure
drives

of search,

resulting

in less than

to be addressed

the social

objective

function

arrangements
price

problem.

is that

is

are predicated

policy

of evidence

If this perception

choice
that

the price level in the social

the U.S. and many

level instability

in a democracy,
is a wealth

convince

is, why introduce

One reason

are changed,

is that,

approximations.

+ oO(p-01)~

function?

and institutional

there

In

employment.
Again,

these

goods.

upon

stable

imposes
should

is not rational,

real costs.

reflect

the public

other

prices,

Another

the peoples

perceives

then

tax systems
and that, until

inflation

it behooves

argument
preference;
as a serious

economists

to so

the people.

Maximizing

the social objective

to the labor demand

function

(lo),

with respect

to p, subject

(5), yields

2
(11)

p=

The expected

(12)

price prior to observing

Substituting

Best policy

this

(9),

and

+ 00).

W)/(Vl

then

+Q).

solving

wage for the control

theory

w,

the

rational

best. It is not optimal

because

for

yields

policy.

rule

The control
the

into

nominal

w)i(?l:

e is, therefore,

pe=(u@r~-7JO77~+771a2+rll

expectations

upon

+77la2-77lf+771

(rJOo]-4071

policymaker
the selected

theory

policy

fails to take
nominal

is not in general
into

wage

consideration
w. There

24

the effect

will exist

a policy

of his policy

-rule
rule of the form

(13)

p=7r()+Ir1

E)

provides

a higher

which

expected

value for the social objective

function.

With

be maximized

with

such a rule,

(14)

Pe = K(),

and

(16)

n=no-nl

The expected
respect

(~-710-7~1

value

model

way, and the conclusion

control
finding

theory

characteristics.8
analysis

would

rule

These

theory

is inappropriate

not addressed

wage rigidities

The problem

yields

assumed

good
that

be much more complicated,

trivial.

complications

should

is that such rigidities

selection.
which

If it were

function

to (14) - (16).7
incorporates

derived

for policy

a policy

of the social objective

to rro and ~1, subject

The assumed

e )+

only

reinforce

if expectations

here is that the nature

or,

in the simplest
do not justify

is one of policy
in this

possible
the use of

design, namely,

case,

best

operating

wage contracts

are overlapping,

and the control

theory

the argument

are rational.
of the contract

that

Another

solution

optimal
problem

is likely to change

the
non-

control
that

is

if policy

changes.

I have not proved here that the best policy lies within the class of linear response functions nor would I
be surprised if it did not. I have established that the control theory solution could be dominated by an
element of the class.
These conclusions are implicit in Fhelps and Taylor (1977, p. 163) when they recognize that monetary
authorities should sometimes penalize the economy in the short run for the sake of beneficial effects
of the rule upon the economys operating characteristics.

25

V. NONNEUTRALITIES
The equilibrium
that

anticipated

demonstrates
whether

through

representative
supplied.

view of business

macro

that

the

policy
way

issuing

household

(17)

(ct -pint

where Og<l

maximizes

is no

proportional

to

proportionality

The

expenditures

does matter.
depend

example

are financed,

The example

upon consumption

in period
the expected

imply

following

t, and nt labor

assumes

and labor

supplied,

the

value of the function

-p2nt),

is the discount

There

or taxation,

whose preferences

POLICY

does not necessarily

effect.

government

ct be consumption

representative

~t,j+

fluctuations

is without

in which

debt

consumer

Letting

WITH ANTICIPATED

rate, and the cli are positive

capital,

labor

and

input;

constant

the

production

measuring

may be taken

parameters.

relationship

output

units

is output

yt

appropriately,

to be one, and the production

the

function

is simply

(18)

y =n

Government

expenditures

the relationship
private

The

bills which

u d

tt+1

The policy
above

+rn

tt

its

due the next

the governments

and

households

do not

affect

intertemporal

expenditures
period.

and

Letting

constraint

debt

obligations

of real purchasing

dt be the debt coming

tax rate, and at the price

budget

past

and the issuance

due

of a real bill coming

is

=gt+dt.

instruments

constraint

instrument,

finances

t, rt the proportional

due next period,

the representative

tax on labor income

come

exogenously

choice.

government

a proportional

in period

(19)

rationalizes

consumption-leisure

through
power

which

gt are determined

are the tax rate and the amount

precludes

their independent

manipulation,

which will be taken to be the tax rate.

26

of the bills issued. The

so there

is but one

For simplicity,
known

it is assumed

distribution

financing

policy

with
in period

and on government
Given

these

that the gt are independent

a finite

second

t depends

expenditures;

assumptions,

draws from some

It is further

only upon debt coming

that

the state

moment.

is,

rt = r(gt,dt),

variables,

assumed

and dt+l

or position

that

due in that period

= d(gt,dt).

of the economy,

are

the pair (gt,dt).

The perfect
corner

production

the

competitive
rule

nt = n,(gt,dt).
will change

the

for

with

problem

equilibrium

in the policy

the ratio of the marginal

elastic

constant

function

no

at real wage 1.
returns

is to determine

to

scale

for a given

employment

is subscripted

utility

(assuming

need not be considered.

labor

nr

ct+l

be 0. For the assumed

is infinitely

along

function

as a result of changes

ct
must

so share ownership

equilibrium

r(gt,dt)

The employment

Equating
supplied

assumption
point

ut

for labor

and dividends,

of

equilibrium

the demand

fixed

rt

assumption

that

competitive

zero profits

policy

(20)

implies

function,

Further,
implies
The

substitutability

solutions)

by

function
r

because

it

r(gt,df).

of ct and the disutility

of labor

to the ratio of their prices, one obtains

=-,

-( 1-rt)

-pl-2P2nt

or

l-P*1
(21)

Labor
that

1
-7,
2fl2

n=-_
t 2P2

employed
period.

in period

Tax

receipts

ut = /3, the equilibrium

(22)dt+l =p

[gt+dt-rt

t is a decreasing
are rtnt,

law of motion

(2

and

linear

from

is obtained:

27

z)].

(20),

function

of the tax rate in

(21), and

the result

that

Because
affect

of the very special

current

labor

consumption

functions.

(23)

-g

l-/J1
ct=n

t
do not

depend

relevant,

the financing

as the expected

household

depends

upon the policy

be the expected

t forward

which

debt

increasing
function

v,(g,d)

(24)

vr(g,d)

where

if the policy

remains

function

is decreasing

n-g

64

= /3-(d+g-rn),

define

and

Nonetheless,

policy

is

flows for the representative

rule followed.
discounted

utility

is rt = r(gt,dt).
with

in d. Proof:

realized

I restrict

certainty;

and r(g,d)

function

by the household

tax policies

next

periods

is increasing

By the recursivity

to those

debt

in d. Result:

is an
The

principle,

there

conditions

is a unique

point

that

a function

of g. The right-hand

of bounded

(measurable)

The fixed points

to verify

to this fixed
decreasing

rule followed.

value of utility

debt;

a mapping

the same set of functions.

it maps

do not

GT

that

policies

employment

It is trivial

of future

equilibrium

and F(.) is the distribution

conclude

the

= c - p ln - p2n2 + p / vr(z,d)dF(z)

l-1*1

(24).

policy

bounded

of current

= 2p2

constraints

expectations

is why

discounted

Let v,(gt,dt)
from period
for

39

upon

This

1
rt - gt .
21-12

=-

assumption,

supply.

decreasing

in that argument.

of this mapping

of (g,d) into

M are solutions

to

of theorem

5 of Blackwell (1965) to
and that M v EM (M nl- v) converges

solution,

for all functions

side of (24) and the

functions

v(g,d).

The operator

in its second

This proves

the result.

28

argument

M has the property

into a function

also

Discussion
If the
taxpayer

representative

matter?

The

depends

on the

answer

is that

is less welfare

expenditures.
government

expenditures

constraint

that

expenditures.
constraint

total

expenditures

and receipts

An interesting
would

followed
policy
debt.

next

The control

the government
taxation

control.

solution,

then,

in the

would

ready
of

be bent

a considerable
many
the

theory

of

the

in chemistry

the present

situations

that

value

when

rather

insisting

of

the only

than matching

upon

an equality

is that the representative

defaulted

to honor

on its existing
future

of

households
debt and then

debt obligations.

The inconsistency

problem

Such a

of the optimal

will again fail to honor

existing

markets.

THE ALTERNATIVE
any

single

being

elapses
appear
mixture
required

observation

accepted

acceptance

Einsteins

observations
demise

equals

is never to honor

or

of a new

prediction

by the gravitational
period

of government
constraints

existing

debt and, as a result,

The result is inefficient

loss to society.

that

hypothesis

confirmation

and then

will not have access to capital

It is unlikely

the

constant

when it is small,

for every t, with the single

in static

the government

VI. TESTING

results

sources

promising

period

and a dead-weight

expectations

rtnt

of tax revenues

of this model

by optimal

is that

replaces

as a

and welfare

a relatively

a given stream

markets

if the government

a given debt policy

is implied

solution

with financing

and

for each match.

feature

increase

problem

equal total expenditures,

to revenue

debt

of debt financing

gt is large and surpluses

gain realized

receipts

types

welfare

when

value

same

expenditures

taxation

equal tax receipts

the present

government

By maintaining

to capital

gt

It is the
is that

is an optimal

deficits

access

the

why does the amount

of taxation.

loss associated

Having

owns

then

this

efficiency

tax rate, and by running

there

household

is liable for its payment,

will

rejected.
theory

from

result
An

or paradigm,

relativity

a new theory

inconsistent

with
and

a generation,

29

the

the

in the

rational

observation

theory

force of the sun, is a rarity.

before
theory

PARADIGMS

which

such
that

as the

light

rays

More typically,

is accepted,

and even then

new

For

acceptance

as described

theory.

example,

of Daltons

atomic

by Kuhn (1970,

p. 135):

Chemists

could

not,

on the evidence,
even after

therefore,

for much

accepting

the theory,

into line, a process

When

of well-known

Similarly,

assuming
beats

as the maximizing

percentage

was different.

period

with rational

paradigm

assumption,

once the subject

The

will elapse

expectations

may be considered

to be fundamental.

information

sets efficiently

assumption
when

surveys

before

the

theory,

be

and

or, for the matter,

in the same spirit

debate

in economics,

expectations

by hypothesizing

that

used

test if some

of much

The rational

maximizing.

cannot

One can only

expectations

the

another

will remain.

the maximizing
and

even

a considerable

into conformity

augmented
observed,

done,

took almost

compounds

expectations

considered

hypothesis.

was

it is accepted,

even then many puzzles

theory
Instead,

had changed.

nature

The rational

it

Daltons

they had still to beat nature

in the event,

composition

economist

but now

which,

generation.

data themselves

simply accept

of that was still negative.

Like utility,
to

test

theory,

irrational

the

whether

assumption

agents

use their

expectations

are not

rational

expectations

it incorporates

expectations,

rational

is or is not consistent

with observations.
In science,
theories.

But,

to stabilize

controlled

experiments

this is hardly

the economy-the

paradigm

equilibrium

phenomena

or the

which

economic

fluctuations

views

policy

invariant

trade-off

law

between

experiment

of

motion.
economics

expectations

theorists

contributing

to uncertainty.

predictions

of the

buy lower unemployment

There
nonmaximizing
confidently
occurred.
income

notable

macro

economic

predicted
function

was mistaken.

as close

hope

this procedure

a perceived

to

a controlled

for. The predictions

of

would

by

fail and that.

unemployment

supporters

that

science.

determined

at exploiting

are

even increase

curve

physical

as

were fulfilled.

higher

inflation

would

were not confirmed.

is another

for

This prediction

consumption

attempts

as one might

might

Phillips

from

of

be used

fluctuations

by an empirically

inflation

that

should

economic

borrowed

Recent
and

used in the testing

hypothesis

views

as generated

employment

in aggregate

which

which

paradigm,

the rational
The

are frequently

the way to test

the

example

the depression,

post-World

was proved
which

of the failure

theory:

related

New maximizing

War

30

and

which

to current

of consumption

accepted

economists

the empirically

consumption

theories

which

II period,

wrong because
current

of a generally

so
never

determined
disposable

were developed

by Modigliani
this failure.

and Brumberg

These theories

the prediction,

subsequently

would have minimal

stabilization

difference

Bogaard

rapid

recovery

more

sophisticated

known.

verified,

tests

(1957)

in response

well since then, generating,

that the temporary

and applications

have appeared

equations,

example,

and by Friedman

to

for example,

tax surcharge

of 1968

effect.

Many suggested
macro

(1954)

have forecast

sometimes

and Theils

from

stochastic,

(1959)

the Great
tests

to

Depression

model

simulate

would

1967)

with

the

have been

did not

random

theory

for

They have all used a set of

economy.

use of the Klein I model

(Prescott,

An econometric

of the use of control

in the literature.

possible.

assume

shocks

For

to show that a

the

was used

Slightly

model

to be

to generate

an

historical
data set. This data set was then used to draw inferences
from the
model, and adaptive control methods were used to select policy actions during
the control
tion

worthless
into

period.

procedure

One could

to obtain

in choosing

the simulated

such

tests

can

economists
tine tune

go one step further

more

demanding

between

the alternative

environment,
assess

the

is a policy

validity

of

do not have sufficiently

the economy,

paradigms

Friedmans

because,

(1953)

selec-

such tests are

incorporated

law of motion.

knowledge

until they

the model

But, even then,

invariant

precise

and that,

and simulate

tests.

At best,

contention

that

of the law of motion

do, they should

to

rely on a neutral

policy.
Kydland
within
rapid

the

and I (1977)

rational

adjustment

by assuming

equilibrium
in capacity

that

capacity

of the expenditures
We simulated

was
makers

use control

theory

assumption

to the policy

rule used.

economy

Econometricians
there

has been

determine

moves

the

function,

the shift in the investment

tax credit

to

change,

new

equilibrium

of the investment

and the policymaker

in turn induces

function

policy

investment

rule. The change in policy

which

period.

is recognized.

31

stabilization

induces

policy

investment

They

to the implementation

the

with some fraction

also

relationship

which

the equilibrium

Subsequent

describing

policy.

investment

to determine
that

with

introduced

in such an environment.

passive

revise their estimate

structural

a new policy

the investment

this

estimated

the incorrect
the

control

associated

lags were

two periods,

policies

and the rest in the second,

and that the function

given
have

required

in the first,

tax credit

costs

Distributed

that a passive investment

in the past,

econometricians

Increasing

assumed.

expansion

the use of optimal

equilibrium,

a class of investment

framework.
were

occurring

The tests assume

was pursued

evaluated

behavior

assume

and

that

that

policy-

rule is optimal,

under

function

is invariant

of this policy
investment

function,

rule,

function.
reasoning

uses optimal
still another

a change in the policy

that

control
change

to
in

rule once

The tests
examples,

found

this

performance

initially

eventually

that the iterative

process

application

of control

simulated
(e.g.,

early

to

a policy

converging

tax credit

policy.

For other

and

iteration

resulted

each

process

captures

increase

theory

economic

environments,
not

equilibrium

observations

between
problem

existence

of a stable

size one cannot

as the

sixties

choose

shift

viewed

that the

and can very well

that,

for equilibrium
planning,

but do

as an equilibrium

consistent

the theories,

or dis-

rational

paradigms

financing

expectations
with

rather

severe

requiring

us to reject

as occurred

in policy.
in the late

theories

which

warrant

to test for an output-inflation

there

being none.

Sargent

classical

hypotheses

and

variables

Similarly,

the

differ.

the key hypotheses

and fiscal-policy

predict

how large the sample

of the theories

evidence

consistent

(p. 236).

both

be used to

A fundamental

Only if there is a change

inflationary

of

cannot

approaches.

rule

do the predictions

the data

rate

experiments

and that no matter

uses international

monetary

or the interest

a policy

incorporating

evidence

government

given

tests

and finds

a model

(1976)
turns

of the model

do not

cause

LIP

that

unemployment

one can find laws of motion

which are

with the data.

VII.

The

primary

but

economic
of a policy

purpose

to discuss

planning.
invariant
when

CONCLUSION

of this paper

whether

optimal

The use of optimal

if expectations

recognized

demonstrate

that simulation

between

are two

trade-off

exist

as this iterative

tests indicate

is hazardous

is best

effects,

no-investment

did not converge,

Insofar

these

and the equilibrium

to peacetime

Lucas (1973)

debate,

tests

law of motion,

and early seventies,

There

little

suggest

is that

mention.
tests

process

not be used for economic

economy

the control

inference

such

the

should

to the

process.

These
choose

These

theory

economic

had detrimental

economy.

stabilization

fluctuations.

whether

the iterative

For some

improved

was inferior

of what is happening,

for macro

control

indicate

examples,

converged.

theory

but then

which

in a less stable

the essence

use of control

iterations),

typically

the

law of motion,
are

rational.

situation

is not
control

control
which

The

to enter

into

is an appropriate

is predicated

economic

predicts

of control
such

device

for

upon the existence

theory

inapplicability

is well understood,

the monetarist

will not
theory

as for patent

is

policy

9 I proposed the use of simulation experiments with many players assuming the roles of households, firms,
banks, forecasters, and policymakers. The near unanimity of opinion among my coUeagues that results of
such experiments would tell one nothing led me to retract this proposal.

32

and management.
from

physics

determined
objects

It is only for aggregate

the

concept

is unlikely

to those obtained
rational

to achieve
purpose

effect,

all theories

for some policy

economy

will be preferred

the foremost
example,
inflations,
affects
until

predict

utilizing

to others,

of the paradigm,

and uncorrelated

comparable

the fallacy

anticipated

that because

monetary

policy

imply that active policy

to economic
operating
is precisely

instability.

Quite the

characteristics
what

Lucas

of the
(1976)

wage contracts

the unanticipated

the anticipated,

of the equilibrium
of the

be used

to be
as inert

component

yet the policy

of

rule followed

of output.

theory

not be attempted.
the

in social science

this paradigm

with

The implication

currency

people

argues. For the long-term

a tested

is available,

that

which

correlated
with

law of motion

modeling

as unlike people.

rules, the equilibrium

is perfectly

the variance

stabilization
stable

advocate

output

that

triumphs

objects

or will contribute

contrary;

invariant

warned

celebrated
physical
theories

be ineffectual

policy

(1941)

that the norm is to borrow

of the essay is to correct

expectations

will have little

will either

Knight

by treating

A secondary
some

of a fixed

empirically.

economics

business
Reliance

price and constant

implication

to predict

the

view of business
cycle

is available

on a policy

economys

operating

policy rules, and that one with good characteristics

33

is that
active

of maintaining

tax rates is appropriate.

of the equilibrium

fluctuations
it is best that

a relatively

Once a tested

view is that
characteristics
be selected.

economic
under

theory
theory

alternative

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