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?
The rational expectations theory is an economic concept whereby people make choices based on their rational outlook, available information and past experiences. The theory suggests that the current expectations in an economy are equivalent to what people think the future state of the economy will become. This contrasts with the idea that government policy influences people’s decision.
New classical economist do not accept the concept of adaptive expectations in Keynesian and monetarist model where economic agent make decision, particular in determine the price level based on the historical level, or the previous price level. New classical oppose the price expectations which assume labor supply is fixed in short run and make difference between short run and long run result in Keynesian and monetarist analysis of the effect of aggregate demand of an output and employment.
New classical propose economic agent will form rational expectations which means that the economic agent will form the expectations based on all the available information concern the variable being predicted. If expectations are rational when forming the aggregate price level, the labor will use all the relevant information and not just the past information. Labor will also use any information that they think the variables can play a role in determine price level. Besides, labor will take account of any anticipated policy action. The assumed to know the effect of the policy to price level.
In Keynesian and monetarist, labor supply is depend on the expected real wage, where money wage divided by expected price level Ns=(w/Pe). Hence, the position of Aggregate supply and labor supply curve depend on the expected price. An increase in expected price level shift both aggregate supply and labor supply curve to the left.
In the New classical model, with the assumption of rational expectations. The expected price level depend on the expected level of the variables that determine the price level. These include expected level of money supply (Me), government spending (Ge), autonomous investment (Ie) and so on.
Compare the effect of expansionary monetary policy between the new Classical and Keynesian on output and employment.
Expansionary monetary policy happen when a central bank uses its tools to stimulate the economy that increases the money supply, lowers interest rate and increases aggregate demand.
Anticipated Expansionary Monetary Policy
In New Classical model, the labor supply curve position is determine by the expected level of variables that determine the price level. Assume there is a fully anticipated increases in money supply, where the central bank announce the increase in money stock to the society. The AD curve will shift to the right from AD0(Mo) to AD1(M1) and causes the price to increase from P0 to P1 and output increase from Y0 to Y1 and new equilibrium is form at E1. Labor demand shift to the right from Nd(MPN*P0) to Nd1(MPN*P1), nominal wage increase to W1 to attract more worker and thus employment increase from N0 to N1 forming a new equilibrium at point B.
Since the position of AS curve is not fix and the expansionary monetary policy is anticipated. Hence, the level of the expected money supply increase, this will increase the expected price level because with rational expectation, labor understand the inflationary effect of an increase in money supply. The labor supply curve will shift to the left from Ns(Me0) to Ns1(Me1), as well as AS curve also shift to left, AS1(Me1).
Shift of AS put forward pressure on increase the price level from P1 to P2. As a result, output restore back to Y0 but end up with a higher price at P2. As price increase again, labor demand curve will also shift to the right again, from Nd1(MPN.P1) TO Nd2(MPN.P2). As a result, in the AD-AS diagram, output restore back to Y0 but end up with high price level at P2. In labor market, employment also restore back to N0, with higher money wage at W2.
With rational expectation, restore back to initial output and employment takes place in short run. In short-run, anticipated policy action will cause an increase in price and nominal wage, leave output and employment unchanged. This mark differences compare with Keynesian and monetarist where in short run, output differ due to fix Pe.
Unanticipated Increase in AD
Increase in money supply shift AD curve to the right become AD1(M1) and causes increase in price from P0 to P1thus increases labor demand from Nd(MPN.N0) to Nd1(MPN.N1), employment increase to N1 and outut increase from Y0 to Y1. If the expansionary policy is unanticipated, these are the only result in the short run. If policy action is unanticipated, output and employment will affected. Unanticipated policy actions is same with Keynesian and monetarist view on the short run short run fluctuation.
If the increase in money supply is unanticipated, it will not affect the labor expectations of the value of aggregate price level so Ns and As will not shift. Even assuming national expectations, labor sometimes canot perceive the inflationary effect of the increase in AD. It is because, compare to classical model, new classical assume economic agent do not have perfect information. They sometimes make mistake in predict in the price level and cause short run deviation of output and employment. In long run, unanticipated will become anticipated, economy restore back to initial level.