Chapter_11 - Chapter 11 Expectations Theory and the Economy...

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Unformatted text preview: Chapter 11 Expectations Theory and the Economy The Phillips Curve also called stagflation this says that policymakers face a trade-off in goals A Phillips curve suggests a negative relationship between inflation and unemployment. americans made this curve their own, they changed it by putting in american data, and they used price inflation rather than the wage inflation rate price inflation in 1966 and 67 phelps and freedman entered the scene and said that in the short run, there is a trade off but in the long run, that trade off disappears and the economy converges to natural unemployment, this meant that any level of inflation can be associated with the same level unemployment Friedman and the Natural Rate Theory • There are two Phillips Curves, not one. • There is a Short Run Phillips Curve, and a Long Run Phillips Curve. • There is a tradeoff between inflation and unemployment in the Short Run, but not in the Long Run. he said that the long run needs to have expectations by using past data to figure out an economic variable, this also called an adaptive expectation, to do this you forecast the future by using past data. workers are fooled because the expectations are no the same as what is actually happening, this happens because the gov and employers dont tell them all the info, this] happens in their mind because their nominal wages rise, but their real wages go down. because of this effect, policy is always going to be unanticipated Friedman’s Natural Rate Theory • Friedman Natural Rate Theory: in the long run, unemployment is at its natural rate. The long-run Phillips curve is vertical at the natural rate. • Adaptive Expectations: expectations that individuals form from past experience and modify slowly. • In the long run, the economy returns to its natural rate of unemployment and the only reason it moved away from the natural unemployment rate in the first place was because workers were “fooled” (in the short run) into thinking inflation was lower than it really was. the philups curve is always a reflection of the as curve, price on the sras curve, inflation and price leve are the same thing.m real gdp and unemployment are related becasue real GDP and unempolyment are inverse functions of themselves. if the SRAS curve shifts to the right, the PC shifts to the left and vise versa Diagrammatically….. so demand rises, so price levels rise, wages rise less than inflation, to employees realize they need more mon they protest for more, they get more and sras shifts left, during this the pc does the opposite Expectations Formation • Adaptive Expectation: an expectation of the future value of a variable formed on the basis of the history of that variable (used in Friedman’s natural rate theory) • Rational Expectation: an expectation that is formed on the basis of all available relevant information (on all variables). Also assumes that the public understands the way the economy works—the structure and linkages between variables in the economy (used in New Classical theory) the rational thing is that they would use all data available to make a prediction policies can either be unanticipated, or anticipated. from anticipated one, there can be either correctly or incorrectly predicted. and from incorrectly there is either over or under anticipated. New Classical Theory • Rational Expectations • All wages and prices are completely flexible with respect to expected change in the price level • Workers try to keep their real wages from falling when they expect the price level to rise • Anticipated policy has no effect on aggregate output and unemployment • Unanticipated policy does have an effect • Policy ineffectiveness proposition Anticipated vs Unanticipated Policy happens over a period of time happens today Policy Ineffectiveness Proposition the ifs are assumptions If: • A policy change is correctly anticipated; • Individuals form their expectations rationally; and, • Wages and prices are flexible. Then: • Neither fiscal nor monetary policy is effective in meeting macroeconomic goals. Policy less Expansionary than Anticipated where it was thought to go where is actually went to but because the sras curve has already shifted to the left, there is a reduction of the recessionary gap yet it is not cured, only a portion is taken away New Keynesian Model • Objection to complete wage and price flexibility because of: – Labor contracts – Reluctance by firms to lower wages – Fixed-price contracts – Menu costs • Model assumes rational expectations but wages and prices are sticky Diagrammatically….. Real Business Cycle Theory • Changes on the supply side of the economy can lead to changes in Real GDP and unemployment. • A decrease in Real GDP can be brought about by a major supply-side change that reduces the capacity of the economy to produce. • What looks like a contraction of Real GDP originating on the demand side of the economy can be, in essence, the effect of what has happened on the supply side. Diagrammatically….. ...
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