Policy Ineffectiveness, the Lucas Critique and Money Neutrality
The view that macro policy is often used in order to fool agents is an extreme variant of NCM's more essential message that macro policy is useless. The basic model consists of the Lucas supply function (now expressed in log price-level terms with y* = 0):
and a demand function where, in a monetarist fashion, the log of nominal money m is the central bank’s policy instrument and g represents the log of autonomous (fiscal) spending:
The solution reveals that only non-anticipated expansionary policy moves exert an impact on output.
Given rational expectations, only random shocks ed and εs let output and prices deviate from their equilibrium values y* = 0 and p* = m + θg∕β, respectively. Thus any policy that follows a predictable rule fails to affect real variables, and it is often further assumed that the policymaker cannot perceive and respond to shocks more timely and efficiently than market agents. Policy inefficiency is to be understood in a dynamic sense: we should not assume that market behaviour remains unaffected from changes of economic policy strategies. This finding, the Lucas critique, is appreciated also on the part of NCM critics like Hahn (1980: 3): “Monetary policy, or indeed any government policy, is part of the economic environment of agents who can learn or deduce what this policy is. But then, in evaluating the policy we must not model the actions of agents as if they were independent of the government’s policy.”In order to elaborate this argument, Sargent and Wallace (1976) first show that in general there are “activist” policy strategies, which dominate Friedman’s fixed-rule recommendation if market expectations remain unchanged.
Let the “true” one-equation model be:
With constant expectations this will be estimated as: 
The variance of the process (7) is:
which is minimised by choosing μ1 = -φ∕β. Equating the mean of process (7) with the policy target:
leads to the selection of μ0 = (y* - c)∕β. Thus running the activist policy rule with optimised coefficients yields the best available result:
This outcome obviously outperforms any fixed-m rule. However, this depends crucially on a no-learning behaviour of market agents who stick to their former fixed-me belief. If, on the other hand, people understand and recalculate the motives and mechanisms of activist policy strategies, the central bank loses its influence on the process (5) due to mt— me.
The extent to which market agents are able to grasp the macroeconomic logic of policy strategies is much under dispute. Sargent and Wallace (1976: 181) believe that rational individuals should anticipate reforms that can be expected to happen, from an analysis of the society’s list of urgent problems:
If rational agents live in a world in which rules can be and are changed, their behavior should take into account such possibilities and should depend on the process generating the rule changes. But invoking this kind of complete rationality seems to rule out normative economics completely by, in effect, ruling out freedom for the policymaker.
For in a model with completely rational expectations, including a rich enough description of policy, it seems impossible to define a sense in which there is any scope for discussing the optimal design of policy rules. That is because the equilibrium values of the endogenous variables already reflect, in the proper way, the parameters describing the authorities’ prospective subsequent behavior, including the probability that this or that proposal for reforming policy will be adopted.The whole argument appears rather hypothetical and normative. It is obvious that NCM aims to establish the money neutrality postulate in an even stronger version compared to simple monetarism. In his Nobel Lecture, Lucas (1996) opposes David Hume on account of the latter’s view that a recession is unavoidable following a monetary contraction. This is illogical, according to Lucas, because a gradual change of the money supply should be regarded as basically equivalent to an administrative change in the standard of the money of account, for example, redefining 1000 old francs as 10 new francs. This finding, however, was said to be too complicated for an economist like Hume, “equipped with only verbal methods”. Lucas restricts the asserted equivalence of a money-of-account recalibration and a change of money growth to a state of perfect markets. So, how could a perceptive observer of the world like David Hume ever be convinced to believe that market societies tend to be organised in a series of Walras auctions?
After some years of debate within the scientific community, the view gained momentum that the NCM project was running into diminishing returns. On the one hand, the rational-expectation campaign appeared as a somewhat sterile exercise of pure logic; it did not prove the convergence of individual learning processes in a dynamic scenario of different beliefs:
Individuals, just as they have their own subjective preferences, have their own subjective ways of learning from experience and thus will develop their own forecasts. Though each of these forecasts may be perfectly rational in the light of the individual’s experience, they may well look irrational in the light of the particular model of an economic observer and they will generally differ from each other. (Niehans 1987: 412; cf. also DeCanio 1979)
On the other hand, the distinction between anticipated and “surprising” actions of monetary policy did not help to understand the pattern of the macro process since the mid- 1970s. NCM was stuck in a dead-end.
The original Lucas model of the business cycle proved to be too successful at explaining why business fluctuations should not be much of a problem; under plausible assumptions about the speed with which information circulates in a modern economy, the model could not explain why monetary disturbances should have any significant effects (and above all, any persistent effects) at all. (Woodford 1999: 23, original emphasis)