(E-Learning Week)
SEMESTER 2 (2017/2018)
Prepared by:
Name Matric Number
Submitted to:
En. Saad Mohd Said
Explain the concept of rational expectations. How does this view on how expectation are formed differ from the assumption that workers formed expectations of current and future price levels based on past information about prices?
Rational expectations is an economy theory that states that when making decisions, individual agents will base their decisions on the best information available and learn from past trends. It is the best guess or prediction for the future. Rational Expectations Theory suggests that an expansionary fiscal policy would convince people that inflation is in the making. Thus, they would adjust their behaviour for the coming inflation. Thus, there would be no gain in output, only inflation. Rational expectations implies that the workings of the economy is understood, and that fiscal and monetary policy will be anticipated rendering the policy ineffective. Rational expectations suggest that although people may be wrong some of the time, on average they will be correct. In particular, rational expectations assumes that people learn from past mistakes. Rational expectations have implications for economic policy. The impact of expansionary fiscal policy will be different if people change their behaviour because they expect the policy to have a certain outcome.

In Keynesian models unemployment is caused by due to rigidity of money wage caused by fixed-wage labour contracts and workers’ backward-looking price expectations. When aggregate commodity demand falls, the demand for labour also falls. But due to money wage rigidity it is not possible to maintain the initial employment level in the short run.

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The rational expectations theory also explains how producers and suppliers use past events to predict future business operations. If a company believes that the price for its product will be higher in the future, for example, it will stop or slow production until the price rises. Since the company weakens supply while demand stays the same, the price will increase. The producer believes that the price will rise in the future and makes a rational decision to slow production, and this decision partially affects what happens in the future. By relying on the rational expectations theory, companies can inadvertently effect future inflation in an economy.

For example, if expansionary fiscal policy causes inflation last year, they will factor this into future expectations. Therefore, in the second year, if the government pursue more fiscal stimulus, unemployment may not fall at all, because people immediately adjust their inflation expectations in response to government policy. Under rational expectations, the Phillips curve is inelastic in the short-term because people can correctly predict the inflationary impact of public policy. According to rational expectations, there is no trade-off even in the short turn.

Compare the effect of expansionary monetary policy between the new Classical and Keynesian on output and employment.

Expansionary monetary policy increases the money supply in an economy. The increase in the money supply is mirrored by an equal increase in nominal output, or Gross Domestic Product (GDP). In addition, the increase in the money supply will lead to an increase in consumer spending. This increase will shift the aggregate demand curve to the right. Expansionary monetary policy aims to increase aggregate demand and economic growth in the economy. Expansionary monetary policy involves cutting interest rates or increasing the money supply to boost economic activity. It could also be termed a ‘loosening of monetary policy’. It is the opposite of ‘tight’ monetary policy.
New Classical View

Figure 1
In expansionary monetary policy, money supply is increase. When money supply is increase,aggregate demand (AD) curve shift to the right from AD0 toAD1. As a result, price(P) and output (Y) increase from P0 toP1 and Y0 to Y1. curve will be offset because labour will not accept the existing money wage and require a higher one, shifting the supply curve of labour (NS) to the left from NS0 to NS1 to compensate for the expected rise in prices. In turn, the aggregate supply (AS) curve will also shift to the left from AS0 to AS1. The only change will be higher money wages and prices (leaving the real wage unchanged) but no increase output (Y).

If the increase in the money supply is not expected (monetary surprise), however, then the aggregate demand (AD) curve will shift up to the right from AD0 to AD1. If it were not expected then labour would initially accept the existing money wage and the labour demand (Nd) would shift from Nd0 to Nd1 as prices increase. In the short run, an unanticipated increase in the money supply will have an effect on output and employment. In the long run, however, as the price level rises labour begins to demand a higher money wage and the supply curve of labour will shift up to the left and there will be no long run increase in Y but money wages and prices will rise.

Figure 2
In Keynesian View, when there is expansionary of monetary policy which is increase in money supply, aggregate demand (AD) curve will shift to the right from AD0 to AD1. Price and output (Y) will increase from P0 to P1 and Y0 to Y1. Then it will move the equilibrium point from point a to b. Inflation will rise due to increase in price.

Due to price and output increase, labour demand (ND) will shift to the right from ND0 to ND1. Money wage (W) and employment (N) will increase from W0 to W1 and N0 to N1. Unemployment will reduce.
In conclusion, Keynesian approach is more effective than new classical approach. This is because Keynesian can overcome either unemployment and inflation temporary. Thus the New Classical Model differs from the Keynesian and Monetarists with respect to anticipated or expected change but not with respect to unexpected or unanticipated change. The New Classical Model does not differ from the Classical Model with respect to anticipated change but does differ in that there is no assumption of ‘perfect knowledge’, i.e., the unexpected can cause changes in output.

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