THE RATIONAL EXPECTATION THEORY : PART TWO

RELATED CONCEPTS :|RANDOM ERRORS |RATIONAL EXPECTATIONS |REAL BUSINESS CYCLE THEORY |SYTEMATIC ERRORS |

If a baseball player has a 300 batting average, why is it unbiased to predict that for every ten times at bat, he or she should have three hits? Why is predicting four hits (out of ten) a biased prediction?

• The forecast of three hits out of ten times at bat is unbiased in the sense that on average it will be right. Sometimes, the baseball player will hit more, sometimes less. Predicting four hits will be right some of the time, but more often it will be too high. So it is biased.

Suppose the Fed announces: “We are not going to increase the money supply” and then surprises everyone by increasing it by 20%. What will happen? If the Fed does this ten times in a row, what will happen the eleventh time?

• The first time this occurs, people will not anticipate the increase in the money supply; Output will increase in the short run. But by the eleventh time, people will anticipate the increase in the money supply, so in the short and long run, only prices will increases. Real output will be unaffected.

Continuing the above question, what will happen the twelfth time the Fed announces: “ We are not going to increase the money supply” if it actually does not increase the money supply that time?

• People will expect prices to rise, so the AS curve will shift up. But the AD curve will be unchanged. So output will fall and prices will rise (there will be a cost-push stagflation). In the long run, output and prices will return to their original levels.

What is wrong with the following theory: “To get elected, the party in power stimulates the economy just before the election. So we can expect an economic expansion during an election year.”

• Over time, people will come to expect this event, and any attempted expansion before an election will just raise prices.

When will an unanticipated decrease in the money-supply growth to 2% likely cause a bigger reduction in output:

a. After a long period of a steady monetary growth of 10%, or

b. After period when money supply on average grew 10% but grew faster and slower at various times.

After (a). After (b), prices will be more flexible, so a decrease in price will have less effect. The Great Depression followed a decade of stable prices, which may explain why it took such a long time for the economy to return to full employment.

When can the government reduce inflation without causing a recession?

• If the public expects inflation to fall, the government can reduce inflation without reducing output (both the AD and AS curve will shift down the long-run aggregate supply curve together). For example, after World War I, Germany was able to go from a 100% inflation rate per day to stable prices without a recession mainly because the public had confidence in the promises of the German leaders to stop inflation.

Does everybody have to have “rational expectations” for the rational expectations model to work?

• No. For example, suppose there is an increase in the growth rate of the money supply that good economic models have anticipated. If enough people hiring workers and making investment decisions have this good forecast, their competition will raise wages and nominal interest rates to reflect the higher rate of inflation. So even if workers and savers don’t know what is going on, the economy will have the rational-expectations results.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

THE RATIONAL EXPECTATION THEORY : PART ONE

RELATED CONCEPTS:|RANDOM ERRORS |RATIONAL EXPECTATIONS | REAL BUSINESS CYCLE THEORY |SYSTEMATIC ERRORS |

Suppose you have the price level forecasts that business leaders have made in the past. How can you tell whether their forecasts are unbiased and without systematic error?

• First, find out whether the forecasts were correct on average. Then find out whether the errors were systematic (i.e., whether mistakes were repeated).

Why don’t rational-expectations economists expect people to make systematic errors in their forecasts?

• A person making systematic errors is making the same costly mistake again and again. If people are rational, they will avoid past errors.

If forecast errors are random, can one predict when a recession is going to occur?

• Only recessions that are due to real causes (such as an OPEC oil price increase) can be predicted. Those that are due to unanticipated shifts in the AD curve cannot, by definition, be anticipated.

Why do workers supply more labor in response to an unanticipated increase in inflation?

• When firms offer workers higher money wages and ask them to work more, workers accept since they think they are getting higher real wages (but in fact inflation will reduce their real wages).

Why will workers supply no more labor in response to an anticipated increase in inflation?

• When workers correctly anticipate inflation, they adjust their wages such that they supply the labor they want and no more.

Why can’t the government stimulate the economy when it is in a recession?

• According to rational-expectations theory, government cannot systematically trick workers and suppliers into producing more, and in particular, it cannot systematically do this whenever the economy is in a recession (since its actions can then be anticipated).

How will an unanticipated expansionary fiscal and monetary policy affect the economy?

• It will increase output in the short run, because aggregate demand will shift right and the aggregate supply curve will not shift.

If firms know the price of their output is going up because people have changed their tastes and increased their demand for firms’ output (this being a real shock), how will firms change their output?

• A change in taste that increases the demand for a good means first, that people are willing to pay more in real terms for the good, and second, that the factors that produced the goods now out of favor are now available to be hired. So the firms will produce more, knowing costs won’t rise to offset their profits from producing more.

If firms know the price increase is due to a nominal shock, how will they change output?

• If the increase in price is only nominal, there are no new available factors from out-of-favor goods. So costs will rise to offset the output’s higher price. Firms will raise their price, not their output.

How can an active discretionary ppgovernmental policy that is designed to increase output actually reduce output in the long run?

• An active discretionary policy adds uncertainty to the economy and reduces the responsiveness of firms to all price changes, whether they are due to real or nominal shocks.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

INFLATION AND UNEMPLOYMENT : PART TWO

RELATED CONCEPTS:|ACCELATIONIST THEORY | COLD TURKEY AND GRADUALISM |DEMAND-PULL AND COST-PUSH INFLATION |EXPECTED RATE OF INFLATION |LONG-RUN PHILLIPS CURVE |NATURAL RATE OF UNEMPLOYMENT |PHILLIPS CURVE |TAX-BASED INCOME POLICY (TIP) |

Use the following Phillips Curve schedule and answer the following questions.

Inflation Rate : 20 14 10 8 7 6.5
Unemployment Rate : 3 4 5 6 7 8
a. If natural rate of unemployment is 6%, what is the expected rate of inflation?
b. If inflation falls from 8% to 7%, what will happen to unemployment (if expectations about inflation don’t change).

a. 8%.
b. Unemployment will rise to 7%.

Workers expect inflation to be 20% and the economy is fully employed. Then the Fed acts to reduce the inflation rate to 10%. What will happen in the short run? In the long run?

• Workers will contract for 20% higher wages, but when prices only go up 10%, employers will find they are paying higher real wage and so will cut back employment. The economy will go into a recession (as AD shifts left). In the long run, both unemployment and lower prices will cause workers to adjust their wages down, so the economy will return to full employment (shifting the AS curve right).

What phase of the business cycle (the demand push or the cost pull phase of an
expansion or recession0 is economy in when these statements are made?
a. “Unions have negotiated for lower wages so as to retain their jobs.”
b. “Unemployment has fallen dramatically as inflation has accelerated.”
c. “Firms have been forced by recent wage hikes to raise their prices and produce less.”

a. Cost-push phase of a recession.
b. Demand-pull phase of an expansion.
c. Cost-push phase of an expansion.

Wage inflation is related to expected inflation by the following equation:
Percent change in Wages = Expected rate of Inflation + Percent change in Productivity
If expected inflation is 10% and productivity increases by 2%, how much will wages change?

• Wages will go up 12%.

“Changes in employment and output are caused by how wages and prices change relative to each other.” Explain.

• When wages (W) rise more quickly than prices (P), real wages (W/P) are increasing and employment will fall (holding technology) and capital constant). When wages rise more slowly than prices, real wages are decreasing, and employment will rise.

Suppose you own International Widget Works. How could you evade wage and price controls before and after they are enacted?

• The trick is to increase your widget price before controls are imposed (since you would not be permitted to increase them after) but also to not lose customers because of your higher price. So you raise your price but offer “special” discounts to your customers (such as coupons, special credit terms, and special volume discounts). Once controls are imposed you can raise your effective price by cutting back on these discounts. If this is not enough, have your customers pay for some of your costs by picking up the product themselves. Have very strict credit terms or even demand cash in advance for widgets. Have many grades of quality, each with its own price, so you can push up your effective price by reducing the quality in each grade. If your product is in high demand, insist that your customers buy something else from you (at an inflated price) before they can get widget.

How could wage and price controls appear to be holding down inflation when in fact they are not?

• If many firms employ the tactics described in the above question, reported prices will not rise. But the effective price of goods will. So inflation will not be stopped. Note that by evading wage and price controls, firms are actually serving the customers, for otherwise there would be shortages of goods and less output.

Copyright 2008 Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

INFLATION AND UNEMPLOYMENT : PART ONE

RELATED CONCEPTS:|ACCELERATIONIST THEORY | COLD TURKEY AND GRADUALISM |DEMAND-PULL AND COST-PUSH INFLATION |EXPECTED RATE OF INFLATION | LONG-RUN PHILLIPS CURVE | NATURAL RATE OF UNEMPLOYMENT |PHILLIPS CURVE | TAX-BASED INCOME POLICY (TIP) |

How can you tell what the expected price level is by looking at the AD/AS diagram?

• The expected price level is where the AS curve intersects the long-run aggregate supply curve (i.e., at full employment).

How can you tell what the expected rate of inflation is by looking at the Phillips Curve?

• The expected inflation rate is where the Phillips Curve intersects the long-run Phillips Curve (at the natural rate of unemployment).

Along a Phillips Curve, how are inflation, unemployment, and output related? What is being held constant?

• More inflation means less unemployment and so more output. The AS curve and the expected rate of inflation are held constant along the Phillips Curve.

In what sense are workers “fooled” by inflation?

• Workers set their wages based upon what they think the price level will be. But if inflation is greater than they expected, they will have been “fooled” into accepting a lower real wage than they wanted.

How will the economy eventually get to the price level where the AD curve intersects the long-run aggregate supply curve?

• If output differs from the full-employment level of output, workers will adjust their expectations and wages so the AS curve shifts the economy along the AD curve towards full employment.

Will a higher rate of inflation always reduce unemployment?

• No. Inflation reduces unemployment only if inflation is higher than expected. If it’s lower than expected, unemployment will go up.

What happens to the Phillips Curve when people expect higher rates of inflation?

• If people expect higher rates of inflation, they will demand higher wages and raise other factor costs. The Phillips Curve and the AS curve will shift up.

Why must inflation accelerate in order to reduce unemployment below its natural rate?

• Because if inflation doesn’t accelerate, the expected rate of inflation will catch up with the actual rate, returning unemployment to its natural level.

What rate of unemployment and what output level can be sustained in the long run?

• Only the natural rate of unemployment and the full-employment level of output can be sustained in the long run.

If wage and price controls worked, how could they help speed the recovery of an economy?

• Wage and price controls could speed the recovery of an economy if they corrected the mistaken judgment of people as to how high prices and inflation will be. This would cause the AS curve to shift more quickly towards full employment.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

MONEY AND AGGREGATE DEMAND - THE MONETARIST MODEL : PART TWO

Using the quantity theory, how will the following events affect the money supply, V, and nominal income (or $GNP)?

Event A: Because of widespread bank failures, the public increases its cash holdings.
Event B: Credit cards become widely used.
Event C: The money supply is reduced.
Event D: The nominal interest rate rises.

Event A: MS down, V down, $GNP down. (This happened in the Great Depression). Note that the change in $GNP is also the change in aggregate demand.
Event B: MS unchanged, V up, $GNP up.
Event C: MS down, V unchanged, $GNP down.
Event D: MS unchanged, V up, $GNP up.

If the money demand equals 5% of income, the money supply is $60, and real GNP is 1,000 units of output, what will the price level be? What will the price level be if the money supply is $120? What happens to nominal income? To real money holdings?

• P = MS/kQ. K is 0.05 and V= 20. In the first case, P equals $1.20. In the second case, $2.40. $GNP equals V times MS, increasing from $1,200 to $2,400. Note that P also equals $GNP/Q. The real money supply (MS/P) equals 5% of real income or $50 (in real dollars). In the first case, it’s $60/1.20, in the second, $120/2.40.

An economic forecaster predicts that output will grow by 4% next year, the money supply will grow at 10%, and V will follow its historical pattern of growing at 3% per year. What will be the predicted rate of inflation?

• 9% (10% + 3% - 4%).

A small country produces 5,000 units of output and has a money supply of $2,000. Its citizens want to hold 10% of their income in money (k = 0.10).
a. What are V, $GNP, P, and the real money supply (MS/P).
b. If the money supply doubles to $4,000 but real output and V stay the same, what will $GNP, P, and the real money supply be?

a. V= 10. $GNP = $20,000. P=$4.00 MS/P =500.
b. $GNP = $40,000. P= $ 8.00. MS/P = 500.

Suppose you believe that over the next thirty years V will increase by 2% annually, output will grow at 3% per year, and the money supply will grow at 9% per year. Would you invest in a thirty-year bond paying 10% if you want a real return of 6%?

• You should believe that inflation will be 8%. The real rate of interest on the bond will only be 2%. You should not buy the bond.

Show with and AD and AS diagram how a decrease in the money supply can cause a recession and how the economy can recover on its own.

• A fall in the money supply reduces $GNP and shifts the AD curve left. In the short run, the short-run AS curve remains unchanged, so prices and output will fall as the economy sinks into a recession. In the long run, the AS curve will shift down as wages fall. This will reduce prices further and shift the economy to the right along the new AD curve to full employment.

Assume that V is constant. Assume the money supply is growing at 10% and output at 3%. The real rate of interest is 5%. What is the nominal rate of interest?
What will happen to interest rates, real and nominal, if the money-supply growth rate drops to 4% and the public has fully anticipated this event?

• Inflation will be 7%. The nominal interest rate will be 12% (5%+7%). If money supply growth falls to 4%, inflation will fall to 1%. The nominal interest rates will fall to 6% (5%+1%). The real interest rate will still be 5%.

In a small country, MS = $300, V= 10, and Q= 1,500.
a. What is P?
b. If MS falls to $250 and the price level does not change, what will happen to Q?
c. If 1,500 is the full-employment level of output, what will P be in the long run?

a. P= $2.00
b. Q= $1,250 (i.e., the economy is in recession).
c. P=$1.67 (when prices fall, the economy returns to full employment).

In terms of the quantity theory, how could unions raise the rate of inflation? Could a 10% inflation rate be explained by union activity?

• Unions do not affect the money supply or V. So they can affect inflation only by reducing output growth. To increase inflation by 1%, they must reduce output growth by 1%. To cause a 10% rate of inflation, they would have to reduce national output by 10%. Unions have never been observed causing output to fall this drastically; They cannot be a major cause of inflation.

Can higher oil prices cause inflation?

• Higher oil prices will not affect the money supply or V. So they affect inflation only by reducing output growth. Some economists estimated that output grew about 1% to 2% slower for several years because of the oil price increases in the ‘70s. Thus, higher oil prices added only 1% to 2% to the inflation rate. So why did our economy have such a high inflation rate (12%) when oil prices went up? Because the Fed dramatically increased the growth rate of the money supply. In Germany and Japan, the inflation rates were low and almost unaffected by the higher oil prices, because the money growth rate was kept low.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

MONEY AND AGGREGATE DEMAND - THE MONETARIST MODEL : PART ONE

What variable affects money demand the most in the Monetarist Model? In the Keynesian Model?

• In the Monetarist Model income. In the Keynesian Model, interest rates.

What two variables determine aggregate demand in the quantity theory model?

• The money supply (MS) and velocity (V).

When we observe output growing faster, does it mean inflation will fall?

• Holding aggregate demand (i.e. MS and V) constant, more output means lower prices. But output may be growing because aggregate demand is increasing. In this case, prices will increase.

Why in the long run, does a change in the money supply not affect anything real, including real output and the real money supply?

• In the long run, prices adjust to assure full employment. The full-employment level of output (Q’) will be unchanged. The real money supply (MS/P) will also be unchanged if V is the same, since MS/P = Q’/V.

Why in the long run, does a change in the money supply change all prices and nominal incomes by the same percent?

• Since Q and V are constant in the long run, the real money supply will be the same. So when MS increases a certain percent, all prices will have to increase the same percent in order that people have the same real money supply.

How does the public, not the government, determine what real money supply it wants to hold?

• If the public wants a certain level of money holdings, it will change its spending and thus the price level until it gets the level of MS/P it wants.

What causes a difference between desired spending and income in the Monetarist Model? In the Keynesian Model?

• In the Monetarist Model, a difference between desired spending and income is caused by either an excess demand for money (MD>MS) or an excess supply of money (MS>MD). An excess demand reduces desired spending, and an excess supply increases it. In the Keynesian Model, the difference is caused by changes in desired spending (particularly investment spending).

If people have an excess supply of money, how do they try to reduce their money holdings?

• People will try to reduce their money holdings by increasing their spending. For one person, this will reduce the person’s money holdings. But for all persons, the sum of all money holdings is fixed and equal to the money supply. By everyone’s effort to reduce their money holdings, total spending and income will go up.

How does fiscal policy stimulate the economy in the quantity theory of money?

• By increasing the interest rate and increasing V.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com