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Vol. 61, No. 4
Posted 1980-04-01

Recent Developments in the Theory of Stabilization Policy

by John B. Taylor

John B. Taylor focuses on current theoretical work on the response of output and employment to changes in aggregate demand. He distinguishes between two approaches: information—based theories in which uncertainties about economy—wide disturbances are emphasized, and contract-based theories in which temporary rigidities in wages and prices are emphasized. The former set of theories, combined with rational expectations, are the foundation of the “new classical microeconomics.” In these models only unanticipated disturbances affect real variables, and systematic policy has no effect on real variables. The contract models, on the other hand, allow for temporary rigidities in wages and prices and therefore yield more traditional conclusions about the short-run response of output and employment to demand disturbances and policy actions. Taylor contrasts the implications of these two approaches for two important issues of stabilization policy: the possibility of improving economic performance of output and employment through systematic variation in policy instruments, and the cumulative output loss associated with anti—inflationary monetary restraint. The information—based models suggest an absence of any gains associated with policy activism and an ability to decelerate inflation without a prolonged or serious rise in unemployment. The contract-based models suggest that there may be gains to policy activism and that there may be sizable costs in terms of foregone output associated with policies aimed at reducing inflation.