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.
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