1
Lecture V
Economics 202A
Fall 2007
Section signups at end of class.
Logs: for those of you who feel overworked (which is probably almost everybody)
you may submit
two
, rather than
three,
logs over the next
three weeks.
We have now finished Lucas and Sargent.
September 11: Taylor model
September 13: 3 questionnaire articles: Kahneman
et al,
Shafir
et al
, Shiller
September 18: Yellen and Shapiro and Stiglitz on Efficiency Wages
September 20: no class
September 25: Akerlof and Yellen on Near Rationality.
September 27: Fehr and Tyran on experimental general equilibrium & Mankiw on
menu costs.
October 4: Akerlof on Irving Fisher on Head; Caballero, Engel & Haltiwanger on
demand for ±durables.²
October 9: Dornbusch on exchange rates
This takes us to the next starred item on the reading list.
I want to start where we ended last time, a bit more hurriedly than expected.
I am going to give a very quick summary.
There are two ingredients for Sargent³s result:
First there are rational expectations.
Because of these rational expectations the expected price level at time t,
which Sargent calls
t
p*
t1
, mimics p
t
except for a whitenoise error term.
As a result the gap between actual inflation and expected inflation is just a
white noise error term,
,
t
.
But then there is another assumption, which is the absence of money illusion.
Because there is no money illusion, the Phillips curve depends
critically
on the
difference between actual and expected inflation, plus another error term.
This is equivalent to saying that the deviation from full employment depends on
the gap between actual and expected inflation, plus this extra error term.
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As a result we find, robustly, no matter what we do, so long as we have such an
aggregate supply equation, that the gap between actual and full employment is of
the form:
(,
t
+ u
t
.
So that is Sargent&s result.
Looking at this formula tells us that there is no serial correlation of output.
And there is no systematic effect of monetary policy.
But there is a critical assumption here.
In reality, aggregate supply
may
depend on the
price level
because there is some
form of money illusion such as
sticky money wages.
If you believe that money wages may be sticky in some form or other, then you
the monetary rule.
The key assumption in his model then is the absence of money illusion.
That is the beginning of today&s lecture.
The most standard answer to rational expectations is the model by John Taylor.
Taylor&s model is a model of
rational expectations
, but it also has
money illusion
of a natural sort.
Lucas and Sargent emphasize
rational expectations
.
But in fact their strongest assumption is probably the total
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 Fall '07
 AKERLOF
 Economics, Inflation, Rational expectations, Xt, difference equation

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