24 R.J. Barro, Rational expectations and the role of monetary policy existence of an active stabilization policy motivates individuals to reduce expenditures that are aimed at augmenting their information sets. If enough consumers believe that, demand eases and the good is likely to actually be less expensive next month. The central policy implication of the rational expectations theory is that: Keynesian policies work in the short run but not the long run Based on the theory of rational expectations, a Classical Economics advisor to the president would This statement most closely reflects the published views of. Explain how the theory of rational expectations means that demand management policy is ineffective Adaptive versus Rational Expectations The natural rate hypothesis, which we learned about in an earlier section, argues that while there may be a tradeoff between inflation and unemployment in the short run, there is no tradeoff in the long run. In the 1992 presidential campaign, candidate Al Gore advocated a more active role for government in economic policy than did candidate George W. Bush. Economists use the rational expectations theory to explain … He used the term to describe the many economic situations in which the outcome depends partly on what people expect to happen. Chapter 36 - Current Issues in Macro Theory and Policy 98. According to the adaptive expectations hypothesis, at the beginning of period 3, decision makers would expect inflation during period 3 to be, According to the Rational Expectations hypothesis, at the beginnig of period 3, decision makers will expect inflation during period 3 to be, In the past year, the value of the Euro has increased from $1.35 to $1.54. Which of the following explains an upward sloping short‐run aggregate supply curve? The rational expectations theory is a concept and theory used in macroeconomics. If the price level increases by more than expected, output can be expected to decrease as a result. Your friend graduated from college 10 years ago and started work at a salary of $40,000. If the Federal Reserve significantly raises monetary growth (and this is unanticipated), economic theory teaches that interest rates. If everything else were constant, this would have led to. Some of those who favor a passive approach to policy disapprove of government intervention in the economy because they think government policy makers do not know which policy is correct. In the evolution of growth theory, one error that economists (and others) have made is to focus on __________, without recognizing the importance of other factors like __________. The people of Idaho would be better off if they bought only goods made in Idaho.". Rational expectations is an economic theory that postulates that market participants input all available relevant information into the best forecasting model available to them. If in 2005, Fed officials announce again that an expansion is planned, the most likely result is that, there will be more uncertainty about the Fed following through on the policies it announces. causes inflation and nominal wages to rise almost immediately as people anticipate the higher inflation rate. Expectations Adaptive: Gordon rejects the logic of the Ratex hypothesis entirely. According to the rational expectations school, when monetary policy makers do exactly what is expected of them, their efforts to stimulate the economy will have no effect either on output or employment. 133. Rational Expectations Theory In economics, a theory stating that economic actors make decisions based on their expectations for the future, which are based on their observations and past experiences. Throughout this series of computer-assisted learning modules dealing with small open economy equilibrium we have alternated between two crude assumptions about wage and price level adjustment. Suppose we observe several years of falling inflation rates for an economy. Economists of the rational expectations school believe that expansionary monetary policy is fully effective only if, According to those who favor a passive approach to policy, a recessionary gap will be eliminated because. B. the public's expectations can influence the outcome of fiscal policy, but not of monetary policy. If the money supply increases by 7 percent, velocity (of money) does not change, and real GDP grows by 2.2 percent, the price level. The aggregate demand curve shifts leftward, moving down along a short-run aggregate supply curve. According to those who favor an active approach to policy, where will the economy in Exhibit 17-1 end up when it achieves its potential output? Rational Expectations and Monetary Policy. Before discovering that the short-run Phillips curve does not show the true long-run situation, policy makers were successful in trying to bring the economy to the zero-inflation, zero-unemployment point on the short-run curve. An important implication of the natural rate hypothesis is that regardless of concerns about __________, the government policy that results in __________ is generally the optimal long-run policy. decrease government spending and/or raise taxes. Which of the following would correspond to movement downward along a short-run Phillips curve? If decision makers underestimate the inflationary impact of these policies. According to the rational expectations model, how would an announcement of expansionary monetary policy affect aggregate output? In general, the faster inflationary expectations adjust, the less macro policy can influence unemployment. Economic theory predicts that the following will result from this regulation, Higher interest rates and a smaller quantity of investment. If the effects of contractionary monetary policy are fully anticipated by decision makers, the policy shifts. Brian's view is. The inflation associated with the oil embargoes of the 1970s illustrated the __________ of the downward-sloping Phillips curve in the long run, as unemployment __________. Modern economic theory points to three particular sources of economic growth. Best ECO 3203 Ch 18 Stabilization Policy Flashcards | Quizlet The main policy conclusion of the rational expectations school is, neither monetary nor fiscal policy can be helpful if firms and households correctly anticipate the plans of policy makers, Given the expected price level, policies for reaching potential GDP will work best if the money supply is, exactly the size that makes prices equal to the prices people expected to prevail. The average U.S. recession (after World War II) has lasted. According to the theory of rational expectations, individuals will respond to expansionary monetary policy by Predicting a higher rate of inflation "A consistent countercyclical policy has no effect on employment and output, since individuals will recognize those policies as … If an improvement in education in the United States increases effective labor, this. It also contrasts with behavioral economics, which assumes that our expectations are to a certain degree irrational and the result of psychological biases. Those who favor a passive approach to policy believe that, lags associated with implementing policies are too long and unstable for discretionary policy to be effective, Problems facing active policy decisions include, An increase in the expected inflation rate will, shift the short-run Phillips curve upward and to the right. AD to the left and SRAS to the right and leads to lower prices (deflation). According to adaptive expectations theory, expansionary monetary and fiscal policies to reduce the unemployment rate are a. useless in the long run. Education levels and reductions in poverty. 5. If the government increase money supply when expectations of inflation are low, they may be able to reduce the real value of government debt. Some economists believe that in the long run the unemployment rate is independent of the inflation rate and so the Phillips curve becomes a vertical line. How do unexpected increases in monetary growth affect interest rates in the short run? If the United States is viewed by foreigners as a great nation in which to invest, this causes the United States to run a, Systematic overestimation or underestimation of inflation, occurs under adaptive expectations but not under rational expectations, The expansionary effects of an increase in government expenditures are at least partially offset if, government borrowing drives up interest rates. an unemployment rate that is at or near the natural rate of unemployment because the actual rate of inflation will not be much different than what people expect, The tax reform of 2001, ushered through Congress by President Bush, included which of the following provisions, all above are correct; tax cuts for rich, tax cuts for poor, tax rebates, The U.S. federal budget deficit for this year is more than four times any previous deficit. incorrect because the real income of the economy is limited by the economy's resources, technology, and institutions. Those who favor an active approach to policy believe that, despite the lags involved, implementing discretionary policy is preferable to inaction, An economy experiencing an expansionary gap, operates in an environment in which labor shortages drive up money wages, real wages, and prices. In other words, according to the rational expectations theory, the intended effect of expansionary monetary policy on … There is no longer any serious debate about whether monetary policy should be conducted according to rules or discretion. To determine how the standard‐of‐living of the average person has changed over time the appropriate measure is the. Real wages will fall shifting the SRAS curve to the right. These ideas were formalized by John Muth, who said expectations are rational if they produce predictions equal to the predictions of the underlying economic model. c) It would increase aggregate output in both the short run and the long run. C. predicting no change in the rate inflation. The consumer price index was 160 ten years ago and 220 this year. During recent times, the U.S. has been running a current account deficit. An economy in which actual GDP exceeds potential GDP means that, self-correcting forces will shift the SRAS curve to the left, Suppose that in 2004 the Fed announced a policy of rapid growth in the money supply, but then put the brakes on money expansion without any announcement. the actual rate of unemployment rises above the natural rate of unemployment, Other things constant, an increase in resource prices, Suppose Gabe Murtaugh deposits $10,000 of currency into a checking account at Wachovia Bank, M1 stays constant, but in the future M1 increases because the bank now has excess, Implications of the second Solow growth model include, both a and c (poor countries should grow faster than rich nations, rich nations only grow when technology advances), Bennett Sorbo says "The more money there is in the economy, the more people spend. On the other hand, the stabilization policy described above completely eliminates fluctuations in P, associated with movements in v,, and therefore makes Pr more predictable at date t-1. Suppose that the Federal Reserve significantly increases the growth rate of the money supply. Similarly, the expected price level at the beginning of the period is expected to hold till the end of the period. 132. During the 1970s in the United States, inflation rates were _______________ by historical standards and the unemployment rate was _______________ by historical standards. According to the theory of rational expectations, this same idea can be applied to inflation forecasts. according to rational expectations theory, if the gov policies in a country are anticipated, then, there is nothing gov can do, even in the short run, to reduce the ecos unemployment rate. They were primarilly caused by rapid economic growth in the U.S. stimulating imports, What is the long run average rate of real GDP growth in the United States, What is the long run average unemployment rate in the United States, What is the long run average inflation rate in the United States. If a central bank realizes velocity is falling sharply, what can they do to guard against declines in nominal GDP? Thus even if expectations are rational, monetary or fiscal policy can influence production and unemployment in the short-run. Increases in foreign income increase aggregate demand; appreciation decreases, During the past 50 years, the long run aggregate supply of the United States has expanded. In its original form, the Phillips curve depicted a situation in which an economy could reduce its unemployment rate by holding the inflation rate steady. As shown in Figure 15-3, if people behave according to rational expectations theory, an increase in the aggregate demand curve from AD1 to AD2 will cause the price level to … If resource owners anticipated a monetary growth rate of 6 percent, but the money supply actually grew at only 2 percent, If an economy is at potential GDP and an expansionary policy is correctly anticipated, the result will be, According to the rational expectations school, a correctly anticipated expansionary monetary policy will. When self-correction works to eliminate an expansionary gap, money wages increase while real wages decrease. Recently the U.S. government sent tax rebate checks and the Fed increased the money supply. What is the opportunity cost of producing one unit of food in China? As a result, all decision makers expect the inflation rate to increase to 6 percent. The theory of rational expectations concludes that: A. the public's expectations can influence the outcome of monetary policy, but not of fiscal policy. With time, which one of the following strategies most likely results in an outward shift in the long run aggregate supply curve? During the period __________, the short-run Phillips curve for the United States was farthest from the origin. Suppose a recession surprises economic forecasters, who did not see it coming. These are, Economists have determined the primary cause of inflation as, When exchange is voluntary between two parties, "Increases in inflation always lead to decreases in unemployment." According to those who favor a passive approach to policy, how will the economy shown in Exhibit 17-2 attain equilibrium at potential output? China has the comparative advantage in producing clothing, The principal of comparative advantage suggests. Which of the following is true of high and variable rates of inflation? Rational Expectations Theory and Macroeconomic Analysis •Implications of rational expectations for macroeconomic analysis: 1.Expectations that are rational use all available information, which includes any information about government policies, such as changes in monetary or fiscal policy 2.Only new information causes expectations to change The real GDP figures reflect changes in the quantity of output and not changes in the, When an economy is producing at full employment output (Y = Y*), One important contribution of Solow's first growth model is the importance of, Diminishing marginal productivity of capital. How does aggregate demand change if foreign incomes increase and the dollar appreciates? Proponents of all forms of expectations generally agree, underprediction of inflation generally leads to lower unemployment. The effectiveness lag for monetary policy is short. Decreases in reserve requirements lead to money supply ________________, because they increase the _______________, China is currently producing 4 units of food and 8 units of clothing. Substantially increase their purchases of Treasury securities. If inflation turns out to be only 4 percent, which of the following is most likely? An expansionary fiscal policy or an easy monetary policy, designed to reduce unemployment, is correctly perceived to lead to higher prices; in consequence, private spending accelerates. C) ineffective compared to fiscal policy. People respond to such rates by spending less time producing and more time protecting. Milton Friedman has argued that a reduction in money velocity is partly to blame for the Great Depression. B. Predicitng a higher rate of inflation. Why is it important to use real rather than nominal GDP figures when making comparisons of output across time periods? Which of the following would best explain this phenomenon? the decision-making lag and the implementation lag. Questio n 18 1 / 1 point According to the quantity theory, if constant growth in the money supply is combined with fluctuating velocity, which of the following is most likely to result? unemployment falls below the natural rate. fall in the short run but rise above their initial level in the long run. Economic growth around the globe is positively related to. A major problem in the conduct of macroeconomic policy is the time it takes to recognize that the economy is experiencing a problem. In the event of a recession, which of the following is the most likely policy stance of those who advocate a passive approach to economic policy? The theory of rational expectations was first proposed by John F. Muth of Indiana University in the early 1960s. Although individual forecasts can be very wide of the mark, actual economic outcomes do not vary in a predictable way from participants’ aggregate predictions or expectations. b) a loose monetary policy. Assuming velocity is stable, the equation of exchange predicts the primary effect of this in the long run will be, A significant increase in inflation over current rates, The Fisher effect implies that the primary long term impact of this action on nominal interest rates is. RATIONAL EXPECTATION MODEL: THE EFFECT OF EXPANSIONARY MONETARY POLICY The effect of a fully-anticipated expansion in money supply, say from M 0 to M 1 can be explained as under. capital stock and natural resources; property rights and regulations. A major problem in the conduct of macroeconomic policy is the time it takes to decide how to deal with the problem the economy is experiencing. In other words, according to the rational expectations theory, the intended effect of expansionary monetary policy on investment, real output and employment does not materialize. B.predicting a higher rate of inflation. both countries would gain if Vietnam traded food for China's clothing. Therefore, the larger the money supply, the better off people are." This is because inflation turns out to be higher than the nominal bond yield they promise to pay. If prices and wages are not flexible, an adverse supply shock is most likely to be followed by, For those who favor an active approach, public policy changes are necessary to cure a recessionary gap because, real wages must fall through price increases rather than waiting for money wages to fall, The inflation associated with the oil embargoes of the 1970s resulted in, increased unemployment because aggregate supply fell, When policy makers have an incentive to announce one policy to shape expectations but then pursue a different policy once those expectations have been formed and acted on, there is. D. incorrectly forecasting what will happen to the price level and employment. In the long run, how would an active approach to a recessionary gap differ from a passive approach to policy? According to the theory of rational expectations, individuals will respond to expansionary monetary policy by: A. You graduate this year and start to work for $50,000. If it increases production of food by 2 units (to a total of 6 units of food), clothing production will. The active approach to monetary policy involves predetermined rules that are followed virtually without exception. c. ineffective in impacting the price level. The early Phillips curve showed a tradeoff between unemployment and inflation because it was drawn for a period in which the main source of instability was aggregate demand. When self-correcting forces cure a recessionary gap, According to the rational expectations theory, monetary policy is fully anticipated and therefore only affects. It is clear from above that people’s anticipations or expectations of inflation and acting upon them in their decision making when expansionary monetary policy is adopted frustrate or nullify the intended effect (that is, increase in real output and employment) of Government’s monetary policy. This article has three major purposes:Illto lay out the basic theoi’v of rational expectations asitrelates to monetary policy in away that stresses its applicability to the real world, 121 to discuss some of the ways that rational expectations models can be altered to give results that refute the policy ineffectiveness proposi- tion and, most importantly, 131 to assess the overall conti-ibution of rational expectations … According to the rational expectations theory, if expansionary macroeconomic policy is to work in the short-run, a "policy surprise" must occur. The primary focus of this proposal is, The goal of supply side fiscal policy is to, implement institutions that lead to increases in resources or technological advancement, In the Keynesian view of the macroeconomy, increased savings. This literature is beginning to help economists understand the multiplicity of government policy strategies followed, for example, in high-inflation and low-inflation countries. When the Federal Reserve unexpectedly increases the money supply, which of the following most likely happens in the short run? c) a expansionary monetary policy. lead to a budget deficit during a recession. Robert Emerson Lucas Jr., an American economist at the University of Chicago, who is … according to the original phillips curve, an expansionary monetary or fiscal policy that causes inflation to increase will also. increases both long‐run and short‐run aggregate supply. b) It would decrease aggregate output. These statements are incorrect because voluntary trade helps both sides. instituting a tax policy encouraging investment at the expense of consumption. A Senator from Arizona recently proposed lower taxes to firms that invest in new equipment. Rational expectations has been a working assumption in recent studies that try to explain how monetary and fiscal authorities can retain (or lose) "good reputations" for their conduct of policy. The unemployment rate is probably above the natural rate. In general, we would expect those who favor a passive approach to policy to believe in, a reduction in unemployment comes at the expense of higher inflation, According to the rational expectations school, people base their expectations about inflation on, According to the passive policy maker's position, an expansionary gap will be eliminated because, the short-run aggregate supply will shift to the left, In Exhibit 17-3, the natural rate of unemployment is, 4 percent because it is on the long-run curve, Those of the rational expectations school, favor monetary rules so that workers and firms do not get any unanticipated surprises from the Fed. an expansion in output and a decrease in prices. Predicting a lower rate of inflation. Which type of lag is that? d. None of the answers are correct. Input prices tend to be stickier than output prices. Often, economic "experts" advise developing nations to prohibit foreign ownership of domestic assets. Unanticipated contractionary monetary policy shifts, AD to the left and temporarily decreases real GDP, Keynesian analysis implies that a planned expansion in the size of the budget deficit is, proper during economic downturns but inappropriate if the economy is already, The crowding‐out critique suggests that, a reduction in private spending resulting from higher interest rates largely offsets the, If policy makers believe an inflationary boom is about to begin and they want to use fiscal policy to combat it, the Keynesian view indicates that they should. A basic example of rational expectations theory is a situation in which a consumer delays buying a certain good because, based on his/her observations and experiences, he/she believes that the price will be less expensive in a month. This problem has been solved! In Exhibit 17-3, if the economy started near point b, and government purchases increased, we would expect the economy in the short run to move to, The Fed is not completely independent because, Congress could rewrite the laws that created the Fed. If the current price level is above the level anticipated when input contracts were set, the actual rate of unemployment falls below the natural rate of unemployment (u < u*), The macroeconomic theories of John Maynard Keynes provided an early explanation for. According to those who favor a passive approach to policy, how will the economy shown in Exhibit 17-1 attain equilibrium at potential output? Question 3 options: a) It would have no effect on aggregate output. According to the rational expectations theory, expansionary monetary policy, causes inflation and nominal wages to rise almost immediately as people anticipate the, If people anticipate and react fully to a contractionary monetary policy, the policy will, If there is no technological progress, in an economy's steady state, the long‐run equilibrium is one in which, Which economist(s) made the following statement: "In order to achieve the nonperfectionist's goal of high enough output to give us no more than 3 per cent unemployment, the price index might have, Suppose the Fed sells $200 million of U.S. securities to the public. If an unanticipated reduction in aggregate demand results in output at less than the full employment output, resource prices fall eventually, directing the economy back to full employment, When there is an increase in the expected inflation rate, the, short-run Phillips curve shifts upward (to the right), The vertical long‐run aggregate supply curve reflects the fact that in the long run, an increase in the price level, does not alter the economy's maximum sustainable rate of output, The big mistake that Samuelson and Solow made in their application of the Phillips Curve was to implicitly assume inflation expectations, Keynesian solutions to the Great Depression focused primarily on. The price of an agricultural commodity, for example, depends on how many acres farmers plant, which in turn depends on the price farmers expect to realize when they harvest and sell their cro… For example, if people know that expansionary fiscal or monetary policy will cause inflation in the long run, they will factor that into their expectations. made more difficult if the natural unemployment rate cannot be easily calculated, there is an inverse relationship between inflation and unemployment, The unemployment rate can remain below the natural rate, but only, with a continuously increasing inflation rate, Rational excectations is a school of thought that argues people form expectations based on, If inflationary expectations increase, we can infer that, the economy is not on the long-run Phillips curve. deflation is a potential future danger, and the Fed should conduct expansionary policy. B) effective only if it is unexpected. The policy surprise may be a a) a quantitative easing policy. This means that the Euro has, appreciated, and Europeans now find U.S. goods cheaper. b. useless in the short run. D) effective only when fiscal policy accommodates it. As shown in Exhibit 17-2, if people behave according to adaptive expectations theory, an increase in the aggregate demand curve from AD1 to AD2 will cause the economy to move: The more people spend, the higher the national income. d) a contractionary monetary policy. Journal of Monetary Economics 2 (1976) 169-183. p North-Holland Publishing Company RATIONAL EXPECTATIONS ATHE THEORY OF ECONOMIC POLICY* Thomas J. SARGENT and Neil WALLACE University of Minnesota, Minneapolis, MN 55455, U.S. A. If the reserve requirement is 25 percent, the currency holdings of the public are unchanged, and banks have zero excess reserves both before and after the transaction, the total impact on the money supply will be a, Income tax rates that produce revenues equal to government expenditures when an economy is at full employment. This is caused in part by, all the above are correct; increased spending on entitlement programs, the bailout of financial firms passed last fall under the leadership of republicans, the fiscal stimulus package passed this spring under the direction of democrats, The proponents of rational expectations believe that, the inflationary side effects of expansionary policies are anticipated quickly and, Evaluate the following statements: "Every time someone in Idaho buys an automobile made in Michigan, Idaho is worse off. Which of the following is true regarding these deficits? If the monetary authorities follow policies that keep the annual rate of inflation steady and low, which of the following is most likely to occur? What method would the Fed likely use to implement this change? This change strategies most likely, technology, and the unemployment rate probably. Not a time lag associated with using discretionary policy to correct an economic that., economic theory teaches that interest rates in the conduct of macroeconomic policy is: a following pairs lags! An active approach to a recessionary gap, according to the theory of rational expectations this. In China, all decision makers expect the inflation rate better off if they bought goods. Even if expectations are to a recessionary gap differ from a passive approach to policy how... Years ago and started work at a salary of $ 40,000 underprediction of inflation generally leads to lower prices deflation... 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