Policy and Controllability Under Rational Expectations

Economic theory does not have a formal model of how announcements of future policies affect economic performance, or how they could be used to manage expectations. We show that rational expectations do not affect the controllability of an economic system in either its static or its dynamic versions, even though their introduction in particular cases may make it impossible for the policymaker to determine certain variables because of policy neutrality or time inconsistency problems. The controllability conditions stated by Tinbergen and subsequent authors therefore continue to hold under rational expectations. Indeed, we find that when they are satisfied the presence of rational expectations may even enhance our power to control an economy over time. This is important because it shows that an underlying equilibrium can exist, even if some of our traditional policy exercises lead to invariance or time inconsistency. For example, it provides the theoretical justification for the recent literature on anchoring expectations so that monetary policy becomes effective enough to achieve or maintain low inflation