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Chapter 27
Rational Expectations: Implications for Policy
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2. 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’
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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
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4. Example 1) Short Run Response to Unanticipated Expansionary Policy
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5. Long Run Response to Unanticipated Expansionary Policy
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Example 2) SR/LR(Once-and-for-all) Response to Anticipated Expansionary Monetary Policy
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Example 3) Over-anticipated Case Can Expansionary Policy Lead to a Decline in Output?
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8. LR adjustment to the above case:
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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.
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11. 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.
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12. 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.
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13. 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
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14. Short – Run Output and Price Responses
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15. Comparison of the Short – Run Response to Expansionary Monetary Policy
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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
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17. 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.
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