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Chapter+14+-+Expectations+and+Economic+Fluctuationsl

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Chapter 14 Study Guide To Accompany Macroeconomics: Theory and Policy By B. Modjtahedit Prepared by T. J. McCarthy and B. Modjtahedi University of California, Davis
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Key Points Rational expectations hypothesis (Lucas): Wages and prices are fully flexible Wrong expectations are costly; people act in their own best interest by trying to form rational expectations (best predictions of the future using all available information) People know more about the prices of what they sell than of all the other goods and services. This results in misperceptions about relative price changes: Prices of what they sell relative to all the other prices.
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Key Points Implications: Unanticipated policy will affect aggregate demand and GDP because it will generate misperceptions about relative prices. Anticipated policy will not affect aggregate demand and GDP because, since anticipated, it will not generate any misperceptions about relative prices. Analysis consists of two steps: 1. Start at the point where the expected AD function and AS function intersect; if actual AD is equal to expected AD, the economy remains at this point and achieves a state of general equilibrium 2. If the actual AD function differs from the expected AD function, the economy moves to a point on the actual AD function, and prices partially adjust (so that the price level is between the expected equilibrium level and the level at which the actual AD function and AS function intersect)
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Unanticipated Expansionary Policy P Y AS AD (2010) In 2011 the money supply increases unexpectedly by 5%, causing AD to shift up by 5%. The economy is in general equilibrium in 2010 Y P E AD (2011) 100 105 Wages and prices would increase by 5% as in the classical model. But the wage and price increase creates misperceptions on the part of both workers and producers. Producers think mistakenly that the demand for their products has increased, so they increase output. Workers believe mistakenly that their real wage has increased, so they supply more labor. So output increases beyond Y P and P does not rise as much as 5%.
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Unanticipated Contractionary Policy P Y AS AD (2011) Y P E AD (2010) 95 100 In 2011 the money supply decreases unexpectedly by 5%, causing AD to shift down by 5%. Wages and prices would decrease by 5% as in the classical model. This creates misperceptions on the part of both workers and producers. Producers think mistakenly that the demand for their products has decreased, so they decrease output. Workers believe mistakenly that their real wage has decreased, so they supply less labor. So output decreases below Y P and P does not fall as much as 5%.
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Anticipated Policy P Y AS AD (2010) In 2010 the Fed announces that in 2011 it will increase the money supply by 5%.
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