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Rational Expectations and Monetary Policy Ineffectiveness
1. The AS-AD model with rational expectations2. Issues of Dynamics Inconsistency
1. The AS-AD model with Rational Expectations
● Often, the consequences of a policy depend on agents expectations about the future.
● To illustrate the possible ineffectiveness of economic policy we consider a simple version of Sargent and Wallace [1976]→ we assume a AS-AD model and consider a Lucas' supply function
where is observed at period t
The case of static expectations● Consider that expectations are given by● The key point for the result is that expectations are
exogenously given● Combining AS and AD curve implies
● This is a Keynesian type model since the AS curve is non vertical.
● The monetary multiplier is given by
The case of rational expectations
● We now consider that agents form rational expectations (they understand the economic model):
● To solve the model we: 1) compute the equilibrium in expected terms in order to determine the equilibrium value of 2) we solve the equilibrium by taking into account of the equilibrium value of expected prices.
● Step 1:
● By using the expression of the expectation we can rewite the AS curve as follows:
● Only monetary surpises affect output, ie. Anticipated monetary policy changes are inefficient→ fluctuations around a vertical AS curve
From Lucas Island to Rational Expectations in General Equilibrium
●
●
The case with wage rigidities
2. Issues of Dynamics Inconsistency
The objective of the Central Bank
Conclusion● The form of Household's expectations is crucial to
understand the functionning of the economy and macroeconomic policy
● Under rationnal expectations monetary policy is in general inefficient→ Neo-classical view of macroeconomic dynamic
→ Inflation bias of the only credible monetary policy of the central bank (no real effect)
● But considering market imperfections (wage rigidities), re-introduce a real effect of monetary policy→ New-keynesian view of macroeconomic dynamic