Money and Banking Chapter 26 Rational Expectations Redux Monetary Policy Implications

Chapter 26 Rational Expectations Redux Monetary Policy Implications CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Describe how the new classical model differs from the standard , model . Explain what the new classical model suggests regarding the efficacy of activist monetary policy . Explain how the new model differs from the new classical model . Assess the extent to which can improve performance . URL books 520

Rational Expectations LEARNING OBJECTIVES . How does the new classical model differ from the standard , model ?

What does the new classical model suggest regarding the efficacy of activist monetary policy ?

Why ?

It turns out that the theory of rational expectations we learned about in Chapter Rational Expectations , Efficient Markets , and the Valuation of Corporate Equities has important implications for monetary policy . In a quest to understand why had such a poor record , especially during the , Len ( University of Virginia ) Robert Lucas ( University of Chicago ) Thomas Sargent ( New York University ) Bennett ( Mellon ) Edward Prescott ( Arizona State ) and other economists of the expectations revolution discovered that expansionary monetary policies can not be agents expect them to be implemented . Conversely , to thwart as quickly and painlessly as possible , the central bank must be able to make a credible commitment to stop it . In other words , it must convince people that it can and will stop prices from rising . Stop and Think Box During the American Revolution , the Continental Congress announced that it would stop printing bills of credit , the major form of money in the economy since , when rebel governments ( the Continental Congress and state governments ) began financing their little revolution by printing money . The Continental Congress implemented no other policy changes , so everyone knew that its large budget would continue . Prices continued upward . Why ?

The Continental Congress did not make a credible commitment to end because its announcement did nothing to end its large and chronic budget deficit . It also did nothing to prevent the states from issuing more bills of credit . Lucas was among the to highlight the importance of public expectations in forecasting and . What matters , he argued , was not what models said URL books 521

would happen but what economic agents ( people , governments ) believed would occur . So in one instance , a rise in the fed funds rate might cause interest rates to barely budge , but in another it might cause them to soar . In short , can be certain of the of their policies before implementing them . Because cross diagrams and the and models did not explicitly take rational expectations into account , Lucas , Sargent , and others had to recast them in what is generally called the new classical model . That new model uses the AS , and AD curves but reduces the short run to zero if the policy is expected . So , for example , an anticipated EMP shifts AD right but immediately shifts AS left as workers spontaneously push for higher wages . The price level rises , but output doesn budge . An unanticipated EMP , by contrast , has the same as described in earlier temporary ( but who knows how long ?

increase in output ( and a rise in by another when the AS curve eventually shifts left ) Now get this can actually decline if an EMP is not as expansionary as expected ! If economic actors expect a big shift in AD , the AS curve will shift hard left to keep at , as in Figure The effect of an unexpectedly weak EMP . If the AD curve does not shift as far right as expected , or indeed if it stays put , prices will rise and output will fall , as in the following graph . This helps to explain why markets sometimes react badly to small decreases in the Fed fed target . They expected more ! Figure ( URL books ' 522

Aggregate Price Level , expected price level ) AS , expected price level ) Aggregate Output , What this means for is that they have to know not only how the economy works , which is enough , they also have to know the expectations of economic agents . Figuring out what those expectations are is quite because economic agents are numerous and often have expectations , and weighting them by their importance is . And that is at . At , nanoseconds from now , expectations may be very different . KEY TAKEAWAYS The new classical model takes the theory of rational expectations into account , essentially driving the short run to zero when economic actors successfully predict policy implementation . The new classical model draws the efficacy of EMP or expansionary fiscal policy ( into serious doubt because if market participants anticipate it , the AS curve will immediately shift left ( workers will demand higher wages and suppliers will demand higher prices in anticipation of inflation ) keeping output at but moving prices significantly higher . URL books 523

Stabilization ( limiting fluctuations in ) is also difficult because can not know with certainty what the public expectations are at every given moment . The good news is that the model suggests that inflation can be ended immediately without putting the economy into recession ( decreasing ) if ( central bankers and those in charge of the government budget ) can credibly commit to squelching it . That is because workers and others will stop pushing the AS curve to the left as soon as they believe that prices will stay put . home a asp ?

URL books 524 New LEARNING OBJECTIVE . How does the new model differ from the new classical model ?

The new classical model aids the cause of , economists who believe that should have as little discretion as possible , because it suggests that are more likely to make things ( especially and ) worse rather than better . The activists could not stand idly by but neither could they ignore the implications of Lucas critique of prerational expectations theories . The result was renewed research that led to the development of what is often called the new model . That model directly refutes the notion that wages and prices respond immediately and fully to expected changes in . Workers in the year of a labor contract , for example , can push their wages higher no matter their expectations . Firms are also reluctant to lower wages even when unemployment is high because doing so may exacerbate the problem in the form of labor strife , everything from slacking to theft , to strikes . New hires might be brought in at lower wages , but if turnover is low , that process could take years to play out . Similarly , companies often sign contracts with their suppliers or distributors , effectively preventing them from acting on new expectations of . In short , wages are sticky and hence adjustments are slow , not instantaneous as assumed by Lucas and company . If that is the case , as Figure Effect of an EMP in the new , anticipated policy can and does , although not as much as an unanticipated policy move ofthe same type , timing , and magnitude would . The Takeaway is that an EMP , even if it is anticipated , can have positive economic effects ( for some period of time ) but it is better if the central bank initiates unanticipated policies . And there is still a chance that policies will backfire if wages and prices are not as sticky as people believe , or if expectations and actual policy implementation differ greatly . Figure iii ' modal URL books 525

Aggregate Price Level , Aggregate Output , a ) Responses to an unanticipated expansionary policy Aggregate Price Level , YA vu Aggregate Output , Responses to an anticipated expansionary policy URL 526 Adherents of the new classical model believe that stabilization policy , the attempt to keep output to a minimum , is likely to aggravate changes in as and economic agents attempt to outguess each by initiating unanticipated policies and economic agents by anticipating them ! New , by contrast , believe that some stabilization is possible because even anticipated policies have some effects due to wage and price stickiness . Stop and Think Box In the early , President Ronald Reagan and Prime Minister Margaret Thatcher announced the same set of policies tax cuts , more defense spending , and monetary policy . In both countries , sharp with high unemployment occurred , but the beast was eventually slain . Why did that particular outcome occur ?

Tax cuts plus increased defense spending meant larger budget , which spells EMP and , that is , large rightward shifts in AD . That , of course , ran directly counter to claims about , which were not credible and hence not anticipated . But the Fed and the Bank of England did get tough by raising overnight interest rates to very high levels ( about 20 percent ! As a result , the happy conclusions of the new classical model did not hold . The AS curve shifted hard left , while the AD curve did not shift as far right as expected . The result was that prices went up somewhat while output fell . Eventually market participants out what was going on and adjusted their expectations , returning to stopping further big increases in . KEY TAKEAWAYS The new model leaves more room for discretionary monetary policy . Like the new classical model , it is and hence realizes that expectations are important to policy outcomes . Unlike the new classical model , however , it posits significant wage and price stickiness ( basically contracts ) that prevents the AS curve from shifting immediately and completely , regardless of the expectations of economic actors . EMP ( and ) can therefore increase over , although less than if the policy were unanticipated ( although , of course , at the cost of higher the analysis of the model still holds ) URL books 527

Similarly , to the extent that wages and prices are sticky , some stabilization is possible because can count on some output response to their policies . The new model is more pessimistic about curbing inflation , however , because the stickiness of the AS curve prevents prices and wages from completely and instantaneously adjusting to a credible commitment . Output losses , however , will be smaller than an unanticipated move to squelch inflation . Some economists think it is possible to minimize the output losses further by essentially reducing the stickiness of the AS by credibly committing to slowly reducing inflation . Inflation Busting LEARNING OBJECTIVE . Can improve performance ?

If so , how ?

FIX FIGURE Fighting requires the central bank to hold the line on AD , even in the face of a leftward shift in the AS curve that causes a recession ( i ) The question is , How much will cost the economy in terms output ?

According to the model , about each percent ! The new classical model , by contrast , is much more optimistic . If the public knows and believes that the central bank will , output won fall at all because both the AD and the AS curves will stay put . Workers won for higher wages because they expect will stay the same . An unanticipated stance , by contrast , will cause a recession . The moral of the story told by the new classical model appears to be that the central bank should be very transparent but opaque ! The new model also concludes that an unanticipated policy is worse than an anticipated and credible one , though it suggests that some drop in should be expected due to stickiness . A possible solution to that problem is to slowly ease money supply growth rather than slamming the brakes on . If the slowing is expected and credible ( in other words , if economic agents know the slowing is coming and fully expect it to continue until is history ) the AS curve can URL books 528

be to some degree . Maybe contracts indexed to will expire and not be renewed , new contracts will build in no or at least lower expectations , or perhaps contracts ( for materials or labor ) will become shorter term . If that is the case , when money supply growth stops , something akin to the unsticky world of the new classical model will hold the AS curve won shift much , if at all and will cease without a major drop in output . How can central bankers increase their credibility ?

One way is to make their central banks more independent . Another is not to repeatedly announce A but do . A third is to induce the government to decrease or eliminate budget . Figure The three major macro models compared Figure The three major macro models compared summarizes the differences between the Lucas model , the new classical model , and the New model . Stop and Think Box URL books

In Bolivia in the half of 1985 , prices rose by percent . Within one month , was almost eliminated at the loss of only percent of gross domestic product ( How did the Bolivians manage that ?

Which theory does the Bolivian case support ?

A new Bolivian government came in and announced that it would end . It made the announcement credible by reducing the government , the main driver of money expansion , in a very credible way , by balancing its budget every single day ! This instance , which is not atypical of countries that end , supports the two rational models over the model , which predicts percent losses in for every percent decrease in the rate . The fact that output did decline somewhat may mean that the policy was not credible at or it may mean that the new model has it right and the AS curve was a little bit sticky . KEY TAKEAWAYS Whether can improve performance depends on the degree of wage and price stickiness , that is , how much more realistic the new model is than the new classical model . If the latter is correct , any attempts at EMP and that are anticipated by economic actors will fail to raise and , in fact , can reduce if the stimulus is less than the public expected . The only hope is to implement unanticipated policies , but that is difficult to do because central bankers can never be absolutely sure what expectations are at the time of policy implementation . On the other hand , inflation can be relatively easily by simply announcing the policy and taking steps to ensure its credibility . If the new model is correct , can be increased over , in the short term only , of course ) because , regardless of expectations , wages and prices can not rise due to contractual commitments like labor union contracts and other sources of stickiness . Inflation can also be successfully fought by announcing a credible policy , but due to wage and price stickiness , it will take a little time to take hold and output will dip below Ym , though by much less than the model predicts . URL books

Suggested Reading Gali , Monetary Policy , and the Business Cycle An Introduction to the New Framework . Princeton , Princeton University Press , 2008 . Lucas , Robert , and Thomas Sargent . Rational Expectations and Econometric Practice . University of Minnesota Press , 1981 . Steven . Rational Expectations . New York Cambridge University Press , 1996 . URL books 531