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
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