Expectations and Macroeconomic Stabilization Policies

1. Expectations and Macroeconomic Stabilization Policies Adaptive and Rational Expectations

2. Adaptive Expectations • Adaptive Expectations • Expectations depend on past experience only. • Expectations are a weighted average of past experiences. • Expectations change slowly over time.

3. Rational Expectations • Expectations that are based on all available information past and present as well as on a basic understanding of how the economy works. • The theory of rational expectations states that expectations will not differ from optimal forecasts using all available information.

4. Rational Expectations • Rational expectations mean that expectations will be identical to optimal forecasts (the best guess of the future) using all available information, but….. • It should be noted that even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.

5. Non-rational Expectations • There are two reasons why an expectation may fail to be rational: • People might be aware of all available information but find it takes too much effort to make their expectation the best guess possible. • People might be unaware of some available relevant information so their best guess of the future will not be accurate.

6. Rational Expectations: Implications • If there is a change in the way a variable moves, there will be a change in the way expectations of this variable are formed. • Therefore, the forecast errors of expectations will be random with a mean of zero, unrelated to those made in previous periods, revealing no discernable pattern, and have the lowest variance compared to other forecasting methods.

7. The New Classical vs. New Keynesian Debate

8. The Fooling Model • Components • Aggregate Supply • Production function • Determines the relationship between employed factors of production and total output. • Labor Market • Determines employment of labor and the real wage. • Aggregate Demand

9. The Fooling Model • The distinctive features of this model are: • All markets clear. • The adjustment process of “market clearing” is the essence of the model. • The market is cleared when it is in equilibrium. • Equilibrium is a state of rest where there are no forces causing change or there are equal opposing forces. • Business cycles can occur only if workers have imperfect information about prices and as a result inaccurately perceive price level changes.

10. Equilibrium LAS P SAS0(Pe0) At point E0, the model is in long- run and short-run equilibrium. AD = SAS = LAS The equilibrium price level is P0 and the full employment equilibrium output is YN E0 P0 AD0 0 YN Y

11. Employment • Assumptions: • Labor demand is determined by the real wage. • When the actual price level changes, workers’ price expectations do not change. • Labor supply is determined by the expected real wage; that is, the nominal wage divided by the price level expected by the workers.

12. The Fooling Model LAS SAS0(Pe0) W/P P Ls(W/Pe) W1/P0 D W0/P0 E0 C P1 C AD1 W1/P1 E0 P0 AD0 Ld(W/P) 0 L0L1 0 L YNY1 Y Real GDP Employment

13. AD-AS Model • The initial equilibrium exists at E0. • At E0, Y equals YN and P equals P0. • The increase in aggregate demand shifts the aggregate demand curve from AD0 to AD1. • The price level rises from P0 to P1, causing the real wage to fall from W1/P0 to W1/P1. • Output increases from YN to Y1. • The new equilibrium exists at C. • At C, Y equals Y1 and P equals P1.

14. Employment • The increase in aggregate demand raises the actual price level and reduces the actual real wage, encouraging firms to hire more workers. • The workers do not realize that the real wage has fallen. As a result, they work more. • At L1, the real wage equals W1/P1 while the nominal wage paid to the workers is W1/P0. • The workers supply L1 labor, moving up the labor supply curve to point D.

15. The Fooling Model LAS SAS0(Pe0) W/P P Ls(W/Pe) W1/P0 D W0/P0 E0 C P1 C AD1 W1/P1 E0 P0 AD0 Ld(W/P) 0 L0L1 0 L YNY1 Y Real GDP Employment

16. Fooling Model: Long Run Adjustment SAS(Ls(W/P1)) P SAS(Ls(W/P0)) When workers realize that the real wage has fallen, they demand a higher nominal wage. The increase in the nominal wage causes the SAS to shift left. A new equilibrium is established at D. P2 D P1 P0 C B AD1 AD0 0 YN Y1 Y

17. Fooling Model: Long Run Adjustment SAS(Ls(W/P3)) P SAS(Ls(W/P1)) SAS(Ls(W/P0)) At point D, the real wage has fallen again, causing workers to demand a higher nominal wage. As nominal wages increase, the SAS shifts left. E3 P3 P2 D P1 P0 C E0 AD1 AD0 0 YN Y1 Y

18. Fooling Model: Long Run Adjustment SAS(Ls(W/P3)) P SAS(Ls(W/P1)) SAS(Ls(W/P0)) Long-run equilibrium is restored at point E3. At this point, the nominal wage has risen such that W3/P3 = W0/P0. E3 P3 P2 D P1 P0 C E0 AD1 AD0 0 YN Y1 Y

19. Long Run Aggregate Supply • The long-run aggregate supply curve is a vertical line drawn at the natural level of real GDP. • It shows that in the long-run expectations are accurate. • It shows that long run equilibrium in the labor market can be achieved at many different price levels but only a single level of output. • Long-run equilibrium occurs when labor input is the amount voluntarily supplied and demanded at the equilibrium real wage.

20. Fooling Model: Summary • Business cycles are explained in this model by permitting the actual price level to differ from the price level expected by the workers. • However, when the workers learn they have been fooled, their price expectations rise and they demand a wage sufficient to regain the original real wage. • The SAS curve shifts up and to the left until output has returned to YN. • The model demonstrates that in the long run shifts in aggregate demand have no long-run effect on real GDP.

21. Rationale Behind the Fooling Model • Friedman claims that firms have more accurate information than workers because they need to know only a small number of prices of particular products and can monitor them continuously. • Workers, however, are interested in a wide variety of prices and have insufficient time to keep careful track of them.

22. Criticisms of the Fooling Model • It is unlikely that workers would be fooled for long because: • Workers buy many goods and would notice quickly when their prices rose. • Expectational errors would be corrected quickly because information about price level changes are readily available from the government and the media. • If a periods of high real GDP were always accompanied by an increase in the price level, workers would learn to predict rising prices when production was high and jobs were plentiful.

23. Friedman-Lucas Model • Assumptions: • Markets clear • Information is imperfect • Expectations are rational • Expectations that are based on all available information past and present as well as on a basic understanding of how the economy works.

24. Friedman-Lucas Model • The Model: • Each firm in the economy produces in very competitive markets. • The firm has no pricing power. • Each firm knows the price of what it produces, but does not know about the prices of other products. • This imperfect information leads to confusion about changes in the overall price level and changes in relative prices that affect the slope of the short-run supply curve.

25. Friedman-Lucas Model • The Model: • The amount of output a supplier chooses to produce depends on relative prices. • If the price of his output is high compared to other prices, he is motivated to work hard and produce more. • If the price of his output is low compared to other prices, he prefers more leisure. • When the supplier makes his decision about how much to produce, he knows the price of his output and forms his expectations about prices of the other goods available using rational expectations.

26. Friedman-Lucas Model • Let all prices rise. • If past movements in the firm’s price have always been accompanied by similar movements in the prices of other firms, the owner will expect relative prices to remain unchanged and will not produce more. • If the firm’s price has experienced unique price movements compared to other firms, the owner may conclude that relative prices have changed, and may produce more or less.

27. Friedman-Lucas Model • Produce More • If the supplier determines that his price rose by more than other prices, he produces more. • Produce Less • If the supplier determines that his price rose by less than other prices, he produces less. • The short-run aggregate supply curve can be written as: Y = YN + h(P - Pe)

28. Output and Price Expectations • Y = YN + h(P - Pe) • P > Pe, • If P > Pe, the supplier works harder, Y rises. • P < Pe • If P < Pe, the supplier works less, Y falls. • P = Pe • If P = Pe, there is no change so Y = YN

29. Friedman-Lucas Model P The Friedman-Lucas supply curve is fixed in position by the price expectations of workers. Real GDP can rise above YN in the blue area only when the actual price level rises above the expected price level. An increase in the expected price level shifts the curve up from SAS1 to SAS 2. LAS SAS2(Pe1) P1 SAS1(Pe0) P0 Y 0 YN

30. Implications of the Model • The major contribution of Lucas’s model is the conclusion that the supply response will be high for firms that have previously experienced unique price movements and low for firms that have experienced price movements that mirror the aggregate economy.

31. Implications of the Model: Business Cycle • Lucas also concluded that the supply response would be higher in countries like the USA where inflation had been relatively stable, making unique price movements in individual prices easier to discern. • This means that smaller changes in the price level lead to larger changes in output and as a result a bigger cyclical response. • The SAS in the USA is more elastic or flatter than the SAS in other countries.

32. Implications of the Model: Macro Stabilization • According to the rational expectations hypothesis, monetary policy actions that individuals and firms anticipate have no effect on real variables such as output and employment. • This is known as the “policy ineffectiveness proposition.” • Only unanticipated policy actions that people cannot predict in advance can influence real GDP and employment.

33. Policy Ineffectiveness Proposition • Let expectations of the price level, Pexp, depend in part on their expectation of how the government will change macroeconomic policy. • Also assume that people can anticipate government policy with a great deal of accuracy; ie. they know the policy rule.

34. Policy Ineffectiveness Proposition • Expansionary monetary policy actions cause an increase in aggregate demand. • If people correctly forecast those policy actions, then they fully anticipate the change in the price level that the actions will induce. • As price expectations change, wage demands change, causing an offsetting change in aggregate supply.

35. Policy Ineffectiveness Proposition AS1 AS2 P Rational expectations cause offsetting changes in AD and AS. P rises but Y remains constant. P2 P1 AD2 AD1 0 Y1 Y Anticipated Policy Changes

36. Unanticipated Policy Changes • If people do not correctly forecast the government’s policy actions, then they do not correctly forecast the change in the price level induced by the policy change. • In this case, as the price level rises output increases along the aggregate supply curve.

37. Unanticipated Policy Actions • Expansionary monetary policy actions cause a rightward shift in the aggregate demand curve. • If people do not correctly forecast those policy actions, then they do not correctly forecast the change in the price level induced by the policy change. • As the price level rises, output increases along the SRAS.

38. Unanticipated Policy Actions AS1 P Only unanticipated policy changes result in a change in output. In this case, both the price level and output rise. P2 P1 AD2 AD1 0 Y1 Y2 Y Unanticipated Policy Changes

39. Summary • The new classical analysis suggests that: • An unanticipated increase in the money supply raises the price level and has no effect on real output and employment • Only unanticipated monetary surprises can affect real variables in the short run.

40. Policy Ineffectiveness: Conclusions • The development of rational expectations ignited a major controversy among economists because the model yielded an implication of policy ineffectiveness that directly challenged the mainstream view that active fiscal and monetary policies are needed to moderate the inherent instability of a market economy.

41. Policy Ineffectiveness : Conclusions • The research on expectations that followed the introduction of rational expectations increasingly supported the rapid expectations adjustment implied by rational expectations over the sluggish adjustment of adaptive expectations. • This suggested that price misperceptions would disappear so quickly that there was no time for countercyclical policies to be implemented. • Later work, however, found evidence that suggested that both unanticipated and anticipated monetary policy affected output and employment.

42. Policy Ineffectiveness : Conclusions • Ultimately, a consensus was reached that the key issue is not how price expectations are formed, but whether changing expectations are really the only important source of output fluctuations. • New approaches rely on underlying sources of friction in the market clearing process to explain business cycles.

43. Rational Expectations and the Sacrifice Ratio • The amount of output lost during disinflation is known as the sacrifice ratio. • The size of the sacrifice ratio depends in part on how fast price expectations adjust. • If they adjust slowly, the sacrifice ratio will be large, but if they adjust quickly, the ratio will be smaller.

44. Rational Expectations and the Sacrifice Ratio • The responsiveness of expectations depends on the credibility and reputation of the monetary authority or the Federal Reserve. • The new classical approach argues that announced changes in monetary policy will have no effect on output and employment if the policy is credible. • If the policy announcements lack credibility, inflationary expectations will not fall sufficiently to prevent the economy from experiencing output-employment costs.

45. Real Business Cycle Model • The real business cycle model explains business cycles in output and employment as being caused by real shocks. • The origins of the business cycle lie in real shocks rather than monetary shocks. • This suggests that changes in the SAS curve and the IS curve, but not the LM curve, explain cycles. • Real business cycle theorists give the largest role to production function shocks or supply shocks.

46. Real Business Cycle Shocks • Supply shocks include the following: • New production techniques and/or new products • New management techniques • Changes in the quality of capital or labor • Changes in the availability of raw materials • Price changes in raw materials • Demand shocks include the following: • Changes in spending and saving decisions • Changes in real government spending • These shocks are assumed to be persistent, tending to fade away smoothly after several years.

47. Real Business Cycle Features • General Features: • Agents try to maximize their utility or profits, given prevailing resource constraints. • Agents form expectations rationally and do not suffer informational asymmetries. Agents may have difficulty determining whether a shock is temporary or permanent, but information concerning the path of the general price level is publicly available. • Price flexibility ensures continuous market clearing so that equilibrium always prevails.

48. Real Business Cycle Features • General Features: • Fluctuations in aggregate output and employment are driven by large random changes in the available production technology. • Fluctuations in employment reflect voluntary changes in the number of hours people want to work. • Monetary policy is irrelevant and has no influence on real variables. • There is no distinction between the short-run and the long-run.

49. Real Business Cycle Model • In real business cycle models, people are assumed to supply more labor when the real wage is high and less labor when the real wage is low. • This propensity to supply more labor during periods of high real wages and less labor during periods of low wages is called intertemporal substitution.

50. Real Business Cycle Model • As a result of intertemporal substitution, real business cycle models explain unemployment as the voluntary decision of workers to reduce their labor supply in response to temporary declines in their real wage. • This means there is no need for government policy intervention to reduce unemployment associated with recession.