Juliana Choo Chia Yee EIA 160252
Explain the concept of rational expectations. How does this view on how expectation are formed differ from the assumption that workers formed expectations of current and future price levels based on past information about prices?
Rational expectations can be defined as on average, people can quite correctly predict future conditions and take actions accordingly, even If they do not fully understand the cause and effect relationships underlying the events and their own thinking. Thus, while they do not have perfect foresights, the construct their expectations in a rational manner that, more often than not, tur out to be correct. Any error that creeps in is usually due to random and unforeseeable causes. Next, in efficient market with perfect or near perfect information, people will anticipate government’s action to stimulate or restrain the economy and will adjust their response accordingly. In other words, rational expectations also can define as an economic concept that individual make choices based on their rational outlook, accessibility information and experiences that they went through. It is different because before any decision is made it consider with available information and concern about the variable that being predicted to form the rational expectation. Thus, when a price level is form with rational expectation, labor will use information that he had to determine the price level. In addition, labor will also consider about the anticipated policy action that may be change. So, the price level rely on the level of the variable.
Compare the effect of expansionary monetary policy between the new Classical and Keynesian on output and employment.
Expansionary monetary policy is a policy by monetary authorities to expand money supply and boost economic activity, mainly by keeping interest rates low to encourage borrowing by individuals, companies and banks. An expansionary monetary policy can involve quantitative easing, whereby central banks purchase assets from banks. An expansionary monetary policy also a risk ramping up inflation.
In Keynesian, it assumes backward looking expectations. In other words, is can be say that projection into future of past experience with current experience absorbed over time. We can explain by using the graph below:
From the graph above, we assume that AS curve is upward sloping in Short Run. When the government using expansionary monetary policy, the Money supply will increase and lead to the AD curve shift to the right from AD0 to AD1. The price will increase from Po to P1 and the output will also increase from Y0 to Y1. From this, when the price is higher the employer can earn a higher profit and this increase the employment.
In New Classical, it assumes forward looking and rational. There will be no systematic error in expectations. We will explain by using the graph below:
From the graph above, we assume that money supply increases and it was expected, the AD curve will shift to the right from AD0 to AD1. As the result, the price and output will increase from P0 to P1 and Y0 to Y1. Price increase will lead to the demand for more worker. From this, ND curve will shift to the right from ND0 to ND1 and money wage will increase W1. Since AS curve is not fix and expansionary monetary policy is anticipated, the expected money supply increase and lead to the increase in expected price level. This is because the labor understood the inflationary effect on money supply. From this, the NS curve will shift to the left from NS0 to NS1. The money wage will increase higher to W2 but the employment will decrease back to the original level at N0. This also lead to the AS curve shift to the left from AS0 to AS1 and the price go higher to P2 and output go back to the original level again which is Y0. With rational expectation, we can see that the output level and the employment level remain unchanged in the original level no matter in short run or long run. In conclusion, in New Classical, there will be no affect from expansionary monetary policy in output and employment while in Keynesian, there will be affect from expansionary monetary policy in the output and employment.