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THEORY Government policy intended to manipulate Aggregate Demand sends misleading signals to economic agents, causing firms to change production and employment. However Robert Lucas ' theory of rational expectations implies that agents cannot be systematically fooled by government policy. If agents have knowledge of how the government makes its policy decisions, then they will use this knowledge in forming their expectations of government policy. When this occurs, their expectations of the government's policy will coincide with the government's intended policy. Thus, the error in agents' expectation of policy will be the result of the random variation of the policy tool around its intended value. This is important because the deviation of the Unemployment rate from the NAIRU and the deviation of output from Potential Output are both determined by the error in expectations of government policy. If the government attempts to change its policy, rational expectations further implies that this change will quickly be incorporated into expectations. Thus, the government is incapable of intentionally and systematically causing errors in policy expectations. The only policy that is capable of affecting output and unemployment, then, is a random policy, which is effectively no policy at all. This means that money is Neutral , a substantial point of contention between the Keynesian and Classical schools of economics. Finally, as policy is ineffective in managing output and employment, the PIP implies that government should use its fiscal and monetary policies to control other variables, such as inflation. EVIDENCE Early studies by Robert Barro found evidence in support of the PIP. However, most later studies have found evidence that monetary and fiscal policy can, in fact, have an effect on output and employment. This implies that economic agents are perhaps not as rational as Lucas, Sargent, and Wallace assumed. REFERENCES
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