Brief History of Macroeconomic Thought and Policy

Answer To Try It Problem

Panel (a) shows an expansionary monetary policy according to new Keynesian economics. Aggregate demand increases, with no immediate reduction in short-run aggregate supply. Real GDP rises to Y₂. In the long run, nominal wages rise, reducing short-run aggregate supply and returning real GDP to potential. Panel (b) shows what happens with rational expectations. When the Fed increases the money supply, people anticipate the rise in prices. Workers and firms agree to an increase in nominal wages, so that there is a reduction in short-run aggregate supply at the same time there is an increase in aggregate demand. The result is no change in real GDP; it remains at potential. There is, however, an increase in the price level.