Rational Expectations: Difference between revisions
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===Effects of Rational Expectations using the | ===Effects of Rational Expectations using the Phillips Curve and the AS/AD Relationship=== | ||
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Using the | Using the Phillips Curve, rational expectations neutralize the monetary policy of the Central Bank by anticipating the increase of the money supply and shifting the curve upward from point 0 (π = 2) to point 1 (π = 4) as seen in the graph. | ||
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[[Natural Rate Theory]] | [[Natural Rate Theory]] | ||
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Latest revision as of 03:51, 26 April 2007
What is Rational Expectations?
Rational expectations in theory is the idea that the public will anticipate the monetary changes of the Central Bank and thus, change the prices and wages proportionately to counteract the monetary policy of the Central Bank. In doing this, the public shifts the price level so that output and employment remain at their natural levels respectively making the monetary policy neutral. There are two assumptions of rational expectations:
- People are rational and have rational economic expectations
- These people’s expectations supercede that of most wage and price takers and setters
Effects of Rational Expectations using the Phillips Curve and the AS/AD Relationship
Phillips Curve
Using the Phillips Curve, rational expectations neutralize the monetary policy of the Central Bank by anticipating the increase of the money supply and shifting the curve upward from point 0 (π = 2) to point 1 (π = 4) as seen in the graph.
AS/AD Relationship
In the AS/AD relationship, the Central Bank increases the money supply causing AD to shift to the right, but with rational expectations, people change their price expectations causing a simultaneous shift in the AS curve leftward from point 0 (P = 0) to point 1 (P =1) keeping output at the natural level. The result of the increase in the money supply with rational expectations causes a higher price level at the same level of output.
What is Wrong with Rational Expectations?
The neutrality of rational expectations requires that nominal considerations do not affect the setting of wages or prices. This, however, is often the case. With employees setting wages at what they believe they should be paid and what consumers believe they should be paying for goods, the neutrality of rational expectations will be violated. The idea of what nominal values should be enables the monetary policy to have an effect on the real output and employment. Therefore, monetary policy can have an effect on stabilizing output and perhaps even allow it to grow in the long run even with rational expectations.
The Missing Motivations in Macroeconomics | Ricardian Equivalence | Dependence of Consumption on Wealth, not Income | The Modigliani-Miller Theorem | Natural Rate Theory | Economic Methodology
