ECON102: Principles of Macroeconomics (2021.A.01)

One hypothesis suggests that monetary policy may affect the price level but not real GDP. The rational expectations hypothesis states that people use all available information to make forecasts about future economic activity and the price level, and they adjust their behavior to these forecasts.

Figure 11.5 "Monetary Policy and Rational Expectations" uses the model of aggregate demand and aggregate supply to show the implications of the rational expectations argument for monetary policy. Suppose the economy is operating at Y_P, as illustrated by point A. An increase in the money supply boosts aggregate demand to AD₂. In the analysis we have explored thus far, the shift in aggregate demand would move the economy to a higher level of real GDP and create an inflationary gap. That, in turn, would put upward pressure on wages and other prices, shifting the short-run aggregate supply curve to SRAS₂ and moving the economy to point B, closing the inflationary gap in the long run. The rational expectations hypothesis, however, suggests a quite different interpretation.

Figure 11.5 Monetary Policy and Rational Expectations

Suppose the economy is operating at point A and that individuals have rational expectations. They calculate that an expansionary monetary policy undertaken at price level P₁ will raise prices to P₂. They adjust their expectations - and wage demands - accordingly, quickly shifting the short-run aggregate supply curve to SRAS₂. The result is a movement along the long-run aggregate supply curve LRAS to point B, with no change in real GDP.

Suppose people observe the initial monetary policy change undertaken when the economy is at point A and calculate that the increase in the money supply will ultimately drive the price level up to point B. Anticipating this change in prices, people adjust their behavior. For example, if the increase in the price level from P₁ to P₂ is a 10% change, workers will anticipate that the prices they pay will rise 10%, and they will demand 10% higher wages. Their employers, anticipating that the prices they will receive will also rise, will agree to pay those higher wages. As nominal wages increase, the short-run aggregate supply curve immediately shifts to SRAS₂. The result is an upward movement along the long-run aggregate supply curve, LRAS. There is no change in real GDP. The monetary policy has no effect, other than its impact on the price level. This rational expectations argument relies on wages and prices being sufficiently flexible - not sticky, as described in an earlier chapter - so that the change in expectations will allow the short-run aggregate supply curve to shift quickly to SRAS₂.

One important implication of the rational expectations argument is that a contractionary monetary policy could be painless. Suppose the economy is at point B in Figure 11.5 "Monetary Policy and Rational Expectations", and the Fed reduces the money supply in order to shift the aggregate demand curve back to AD₁. In the model of aggregate demand and aggregate supply, the result would be a recession. But in a rational expectations world, people's expectations change, the short-run aggregate supply immediately shifts to the right, and the economy moves painlessly down its long-run aggregate supply curve LRAS to point A. Those who support the rational expectations hypothesis, however, also tend to argue that monetary policy should not be used as a tool of stabilization policy.

For some, the events of the early 1980s weakened support for the rational expectations hypothesis; for others, those same events strengthened support for this hypothesis. As we saw in the introduction to an earlier chapter, in 1979 President Jimmy Carter appointed Paul Volcker as Chairman of the Federal Reserve and pledged his full support for whatever the Fed might do to contain inflation. Mr. Volcker made it clear that the Fed was going to slow money growth and boost interest rates. He acknowledged that this policy would have costs but said that the Fed would stick to it as long as necessary to control inflation. Here was a monetary policy that was clearly announced and carried out as advertised. But the policy brought on the most severe recession since the Great Depression - a result that seems inconsistent with the rational expectations argument that changing expectations would prevent such a policy from having a substantial effect on real GDP.

Others, however, argue that people were aware of the Fed's pronouncements but were skeptical about whether the anti-inflation effort would persist, since the Fed had not vigorously fought inflation in the late 1960s and the 1970s. Against this history, people adjusted their estimates of inflation downward slowly. In essence, the recession occurred because people were surprised that the Fed was serious about fighting inflation.

Regardless of where one stands on this debate, one message does seem clear: once the Fed has proved it is serious about maintaining price stability, doing so in the future gets easier. To put this in concrete terms, Volcker's fight made Greenspan's work easier, and Greenspan's legacy of low inflation should make Bernanke's easier.