1. Copyright  2011 Pearson Canada Inc. 27 - 1 Chapter 27 Rational Expectations Theory or New Classical Macroeconomic Theory

2. Copyright  2011 Pearson Canada Inc. 27 - 2 Econometric Policy Evaluation Econometric models are used to forecast and to evaluate policy Lucas critique, based on rational expectations, argues that policy evaluation should not be made with these models –The way in which expectations are formed (the relationship of expectations to past information) changes when the behavior of forecasted variables changes –The public’s expectations about a policy will influence the response to that policy

3. Copyright  2011 Pearson Canada Inc. 27 - 3 New Classical Macroeconomic Model All wages and prices are completely flexible with respect to expected change in the price level Workers try to keep their real wages from falling when they expect the price level to rise Anticipated policy has no effect on aggregate output and unemployment Unanticipated policy does have an effect Policy ineffectiveness proposition

4. Copyright  2011 Pearson Canada Inc. 27 - 4 Case 1: Short Run Response to Unanticipated Expansionary Policy

5. Copyright  2011 Pearson Canada Inc. 27 - 5 Case 2: Short Run Response to Fully Anticipated Expansionary Policy

6. This is called Policy Invariance Theorem: “Fully Anticipated Monetary Policy will have no impacts on Real Variables such as Real Income Y”. What kind of Policy will be fully anticipated in a democratic country? If the policy is based on ‘Deterministic Feedback Rules’ such as M t+1 = a + b UE t. Copyright  2011 Pearson Canada Inc. 27 - 6

7. Application of PIT “Disinflation Policy” Inflation or a higher price level has inefficiency in the economy (=Social Cost =Deadweight Loss); We can lower the price level or the rate of inflation without any negative impact on Y by changing Monetary Policy(slowing down the Money creation) as long as it is fully anticipated. Copyright  2011 Pearson Canada Inc. 27 - 7

8. Copyright  2011 Pearson Canada Inc. 27 - 8 Case 3: Over-anticipated Increase in Money Supply

9. New Keynesian Macroeconomics Theory - Not well established yet compared to the New Classical Macroeconomics Theory Copyright  2011 Pearson Canada Inc. 27 - 9

10. Copyright  2011 Pearson Canada Inc. 27 - 10 Short-Run Response to Expansionary Policy in the New Keynesian Model

11. Copyright  2011 Pearson Canada Inc. 27 - 11 Implications for Policymakers There may be beneficial effects from activist stabilization policy Designing the policy is not easy because the effect of anticipated and unanticipated policy is very different Must understand public’s expectations

12. Copyright  2011 Pearson Canada Inc. 27 - 12 Short – Run Output and Price Responses

13. Copyright  2011 Pearson Canada Inc. 27 - 13 Comparison of the Short – Run Response to Expansionary Policy – Traditional Model Figure 27-5(a)

14. Copyright  2011 Pearson Canada Inc. 27 - 14 Comparison of the Short – Run Response to Expansionary Policy – New Classical Model Figure 27-5(b)

15. Copyright  2011 Pearson Canada Inc. 27 - 15 Comparison of the Short – Run Response to Expansionary Policy – New Keynesian Model Figure 27-5(c)

16. Copyright  2011 Pearson Canada Inc. 27 - 16 Stabilization Policy Traditional –It is possible for an activist policy to stabilize output fluctuations New Classical –Activist stabilization policy aggravates output fluctuations New Keynesian –Anticipated policy does matter to output fluctuations –More uncertainty about the outcome than Traditional

17. Copyright  2011 Pearson Canada Inc. 27 - 17 Anti – Inflation Policy in the Traditional Model Figure 27-6(a)

18. Copyright  2011 Pearson Canada Inc. 27 - 18 Anti – Inflation Policy in the New Classical Model Figure 27-6(b)

19. Copyright  2011 Pearson Canada Inc. 27 - 19 Anti – Inflation Policy in the New Keynesian Model Figure 27-6(c)

20. Copyright  2011 Pearson Canada Inc. 27 - 20 Credibility in Fighting Inflation Public must expect the policy will be implemented New Classical –Cold turkey New Keynesian –More gradual approach Actions speak louder than words

21. Copyright  2011 Pearson Canada Inc. 27 - 21 Impact of the Rational Expectations Revolution Expectations formation will change when the behavior of forecasted variables changes Effect of a policy depends critically on the public’s expectations about that policy Empirical evidence on policy ineffectiveness proposition is mixed Credibility is essential to the success of anti-inflation policies Less fine-tuning and more stability