Assume that people have rational expectations and that the economy is described
ID: 1109753 • Letter: A
Question
Assume that people have rational expectations and that the economy is described by the
sticky- price model. Explain why each of the following propositions is true.
1. Only unanticipated changes in the money supply affect real GDP. Changes in the
money supply that were anticipated when prices were set do not have any real ef-
fects.
2. If the Fed sets the money supply at the same time as people are setting prices, so that
everyone has the same information about the state of the economy, then monetary
policy cannot be used systematically to stabilize output. Hence, a policy of keeping
the money supply constant will have the same real effects as a policy of adjusting
the money supply in response to the state of the economy. (This is called the policy
irrelevance proposition.)
3. If the Fed sets the money supply well after people have set prices, so that the Fed
hascollectedmoreinformationaboutthestateoftheeconomy, thenmonetarypolicy
can be used systematically to stabilize output.
Explanation / Answer
1) Only unanticipated changes in money supply can affect real GDP . We know that people are rational so they take into account all information available . Hence they already calculate the eects of anticipated changes in money when they form their expectations of the price level that will prevail in the economy . If there is no surpise changes then output remains unaltered . Whereas if money supply increases more than expected , output rises but only the unanticipated part of the money growth increases output .
2) The central bank wants to stabilize the economy by curbing shocks to output and unemployment . As for example increasing money supply during recession and contractionary money supply during inflation . The bank can only do so by a surprise attack on the price level . If people are rational they will know the exact move FED is going to take . People will know that if there is a recession the FED is ging to reduce money supply . People take into account the systematic, anticipated movements in money, the eect on output of systematic, active policy is exactly the same as a policy of keeping the money supply constant . So policy cannot be used effectively .
3) If FED sets money supply later on , after the people have set prices , and also the money supply is set as a surprise shock before the people can anticipate it , then the monetary policy can be effective . Since people had already made expectations and the actions taken by FED was a surprise .