© 2008 Pearson Education Canada Chapter 27 Rational Expectations: Implications for Policy © 2008 Pearson Education Canada

New Classical Macroeconomic Model All wages and prices are completely flexible with respect to expected change in the price level(assume no labor union for now) Workers try to keep their real wages from falling when they expect the price level to rise Anticipated Monetary Policy has effects only on nominal variables such as Price Level or nominal wages, but it has no effect on real variables such as aggregate output and unemployment Only Unanticipated Monetary Policy does have an effect -> This is called ‘Policy Ineffectiveness Proposition/Theorem’ © 2008 Pearson Education Canada

© 2008 Pearson Education Canada The Modification Recall money wage was a shift variable of SAS Now expected price level is a shift variable of Lucas Aggregate Supply Curve = Expectations Augmented Aggregate Supply Curve © 2008 Pearson Education Canada

Example 1) Short Run Response to Unanticipated Expansionary Policy © 2008 Pearson Education Canada

Long Run Response to Unanticipated Expansionary Policy © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Example 2) SR/LR(Once-and-for-all) Response to Anticipated Expansionary Monetary Policy © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Example 3) Over-anticipated Case Can Expansionary Policy Lead to a Decline in Output? © 2008 Pearson Education Canada

LR adjustment to the above case: © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Example 4) Really Dangerous Case: Strong Labor Unions and Hasty Government Intervention We have seen that in the Long Run, everything will short out by itself in the two above case. When does it not happen? -Initial situation is the same as Example 3, resulting in recession. -To get rid of recession, government pumps MS. -Expecting more inflation, people demand higher wages, and strong labor unions get them. © 2008 Pearson Education Canada

© 2008 Pearson Education Canada

Implications for Policymakers Distinction between effects of anticipated and unanticipated policy actions Anticipated monetary policy has no ‘real’ effect Unanticipated = ‘surprise’ monetary policy has real effect – not sustainable in democratic society. © 2008 Pearson Education Canada

Is this really sustainable in the Long-run? Contract format is endogenous, and can change in the long-run. Union power could be a lot stronger than is assumed in this case - Refer to Example 4 above. © 2008 Pearson Education Canada

Implications for Policymakers There may be beneficial effects from activist stabilization policy Designing the policy is not easy because the effect of anticipated and unanticipated policy is very different Must understand public’s expectations © 2008 Pearson Education Canada

Short – Run Output and Price Responses © 2008 Pearson Education Canada

Comparison of the Short – Run Response to Expansionary Monetary Policy © 2008 Pearson Education Canada

© 2008 Pearson Education Canada Stabilization Policy Traditional It is possible for an activist policy to stabilize output fluctuations New Classical Activist stabilization policy aggravates output fluctuations New Keynesian Anticipated policy does matter to output fluctuations More uncertainty about the outcome than Traditional © 2008 Pearson Education Canada

Impact of the Rational Expectations Revolution Expectations formation will change when the behavior of forecasted variables changes Effect of a policy depends critically on the public’s expectations about that policy – Fully anticipated monetary policy has no ‘real’ impacts. Monetary Policy should not be fine-tuning of Y, but should adopt a constant growth rate policy. © 2008 Pearson Education Canada