WILLIAM FELLNER American Enterprise Institute TheCredibility Effect andRational Expectations: Implicationsof the GramlichStudy EDWARD GRAMLICH'SSTUDY in this issue raises a question by a method thathas frequentlybeen found fruitfulin scientificefforts. He presentsan interpretationof observeddata in termsof a widelyused analyticalframe- work that points to a very unfavorabledistribution of the consequences of demanddisinflation by undesirableoutput effects, on the one hand, anddesired price effects on the other.Yet he directsattention to the possi- bility that a reconstructionof the standardframework could reduce the weaknesseshe detectsin the interpretationhe presents.He does not favor the specificreinterpretation that I have suggestedin variouswritings1 and I will describebelow-indeed, he leans perhapsmore to an attitudeof doubt in this regard-but he has an open mind aboutthe methodsof im- provingthe conventionalframework. Essentially, he plays into the hands of all those of us who areeven moreskeptical than he is aboutthe conven- tional way of going about macroeconomicmodeling and who believe in the superiorityof a specificalternative. I would like to make use of the opportunityhis work provides.This is done partly with referenceto his empiricalfindings, to whichI turnin the thirdsection, afteran attemptto place the matterin perspective. The IncompleteOverlap between Two Hypotheses Conclusionsderived from analysisincorporating what may be termed the credibilityeffect overlap with conclusionsfrom analysis commonly 1. For instance, in Fellner, Towards a Reconstructionof Macroeconomics:Prob- lems of Theory and Policy (American EnterpriseInstitute, 1976). 0007-2303/79/0001-0167$00.25/0 ? Brookings Institution 168 BrookingsPapers on Economic Activity, 1:1979 associatedwith the hypothesisof rationalexpectations. Both hypotheses lead to a criticalattitude concerning essential features of the macroeco- nomic models most frequentlyused, but the two hypothesesneed to be distinguishedfrom each other.In this paperI brieflyjustify this statement and arguein favor of the hypothesisstressing the credibilityeffect. My conclusionis that once one eliminatesthe unconvincingelements from the rationalexpectations hypothesis, one is left with the credibilityhypothesis as it is here interpreted.The hypothesesunder consideration have the fol- lowingmain properties. Standardmodels-The frameworkspresently regarded as conventional explain the currentwage and price increaseof a period in large part by the precedingwage and priceincrease, though other variables such as the "slack,"usually measured by the unemploymentrate, also enter into the explanation.Expectations concerning future demand-management policy enterhere merelyimplicitly through the assumptionthat-for any chosen value of othervariables such as the slack-the pastmoney-wage and price increasesdetermine the currentwage increases by unchangingcoefficients. At the same time, in these models the currentmoney-wage increases play a very large role in determiningthe currentprice increases,also by un- changing coefficients.Thus there is no room in the standardmodels for the hypothesisthat a perceived change in the likely future conduct of demand-managementpolicies-in the consistency of those policies- would alter the effect of past wage and price increaseson the currentin- creases,or would alterthe currentincreases that become associatedwith any currentlyobserved slack. Both the credibilityhypothesis and the ra- tional expectationshypothesis are critical of the assumptionthat the money-wageand the price trend are insensitiveto the perceivedpolicy posture,except insofar as that postureexpresses itself in the currentlyob- served slack given the other variablesspecified in the standardmodels. The credibility hypothesis-The hypothesis of the credibility effect maintainsthat marketexpectations, and thus the effect of past money- wage and price increasesand of any currentlyobserved slack on current money-wageand price increases, are significantlyinfluenced by the ex- pectedfuture behavior of policymakers.Emphasis is placed on the differ- ence between states of the economy in which inconsistentpolicies lead marketparticipants to formdiffuse personal probability distributions with risk allowancesplaying a largerole in their decisionmaking,and states of the economyin whichfirm and crediblepolicies condition the public'sex- WilliamFellner 169 pectationsand lead to much more strongly peaked and widely shared personalprobability distributions concerning future events. In particular,the hypothesismaintains that standard-modelcoefficients suchas those estimatedfrom Gramlich'swage-increase equation 1' would changesignificantly for the better-in the directionof a muchmore rapid reductionof inflationfor any given slack-if a demand-managementpol- icy, whichwith brief interruptions was accommodativeduring a largepart of his sampleperiod, changedto a crediblepolicy of consistentdemand disinflation.This change in policies would have a major effect on price expectations,and the estimatedcoefficients would turn out to have over- stated the effect of the laggedprice and wage increaseson the currentin- creases.Allowance needs to be madefor a transitionperiod during which lags in establishingcredibility, as well as past contractsand their tempo- rary influenceon new contracts,would continueto slow the process of price deceleration.But thereafterprice decelerationwould speed up sub- stantially,the public'sobjectives being set in real terms. For analogousreasons the hypothesismaintains that coefficientssuch as those of Gramlichunderstate the currentincreases in relation to the precedingwage and price increasesfor alternativelevels of the slack if the authoritiesshift from a firm and credible anti-inflationarypolicy to one that accommodatesinflation with minor and sporadicinterruptions. Consideringthat during Gramlich'ssample period (1954-77) a pro- nouncedshift from credibilityto laxity did in fact occur in this sense, the hypothesissuggests that duringthe sampleperiod the deviationsobserved from the values predictedby the model should show a tendencyto turn fromnegative to positive.2In otherwords, along with the loss of credibility of the anti-inflationarypolicy posture,the given values of Gramlich'sex- planatoryvariables should show signsof becomingassociated with steeper cost trends. The rational expectations hypothesis-Views based on the credibility hypothesis overlap with views usually associated with the hypothesis of rationalexpectations. I amreferring to a set of viewsas beingcommonly associatedwith "rationalexpectations" because there obviouslyexists no joint declarationof authorsin such mattersand becausein some ways the views i.nquestion are still evolving.But to the extent that it is possibleto speakof jointlyheld views of authors,I do not believe that the proposi- 2. Gramlich did not correct for serial correlation, which, I am told, was not found to be significant. 170 Brookings Papers on Economic Activity, 1:1979 tions I regardas characteristicof analysisbased on the rationalexpecta- tions hypothesiswould misrepresent the views of the authorsconcerned.3 (It wouldbe far-fetchedto base an appraisalof the debateon a qualifica- tion to be describedin note 4 below.) The rationalexpectations hypothesis overlaps with that of the credi- bilityeffect, because both stressthat the publicis formingits expectations on the basis of all availableinformation, including information on the probablefuture actions of policymakers.However, there are two reasons whythe overlapis merelypartial. One reasonis that the views commonlyassociated with the rationalex- pectationshypothesis suggest that experiencehas in fact enabledthe pub- lic to detect a system by which the authoritiesexert an influence on nominaldemand, while the credibilityhypothesis suggests that the public can detect such a system only if the authoritiesplay effectivelyinto the hands of the marketparticipants by behavingconsistently in an under- standablefashion. Consider,for example, a mode of behavior of the policymakersde- scribedby the accommodationof a so-calledunderlying inflation rate in order allegedlyto stabilizethat rate, and considera policy that continues to accommodateinflation when the underlyingrate steepens(as it will in such circumstances),yet becomes temporarilyrestrictive at some rate of acceleration-not the samerate on successiveoccasions. The lattermode of behaviorillustrates game-strategy situations leading to highly volatile marketexpectations and to largerisk allowances.This descriptionfits the post-1965 policy postureof our authoritiesregrettably well. It cannotbe expectedto result in a state of the economyusefully described as one in which a system governingpolicy behaviorhas been figuredout by the public. Dependenceof the suggestedconclusions on the conditioningof market 3. For relatively recent contributionssee, for example, Thomas J. Sargent, "Ra- tional Expectations, the Real Rate of Interest, and the Natural Rate of Unemploy- ment," BPEA, 2:1973, pp. 429-80, and "'Rational Expectations': A Correction," BPEA, 3:1973, pp. 799-800; Thomas J. Sargent and Neil Wallace, "Rational Expectations and the Theory of Economic Policy," and Robert J. Barro and Stanley Fischer, "Recent Developments in Monetwy Theory," Journal of Monetary Eco- nomics, vol. 2 (April 1976), pp. 169-83 and 133-67, respectively; Robert J. Barro, "UnanticipatedMoney, Output and the Price Level in the United States,"Journal of Political Economzy,vol. 86 (August 1978), pp.