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$4.$ The rational expectations model

Suppose the U$.$S$.$ economy is in equilibrium at a potential output of $$6$ trillion so that unemployment is at the natural rate. At the beginning of the year, the Federal Reserve announces that its monetary policy will aim to maintain output at potential output and sustain the current price level throughout the year. Firms and workers negotiate annual wage and resource price agreements based on the belief that the Fed is committed to price stability.

The following graph shows the aggregate demand curve $($AD$),$ the long$-$run aggregate supply curve $($LRAS$),$ and the short$-$run aggregate supply curve $($SRAS$)$ at an expected price level of $80.$

Now suppose that several months later, the Fed abandons its stated goal of price stability and shifts toward an expansionary monetary policy.

On the following graph, show the short$-$run effect of this policy by shifting the appropriate curve or curves.

In the short run, the expansionary monetary policy will result in a price level of

In the short run, the expansionary monetary policy will result in a price level of

On the previous graph show the long$-$run effect of the expansionary monetary policy by shifting the appropriate curve or curves.

Because the wages workers agreed upon at the beginning of the year now buy $q,$ than had been expected in real terms, workers eventually renegotiate wages, assuming a price level of

Suppose next year, the Fed once again announces that its monetary policy is aimed at maintaining price stability at the level reached last year $($the price level you found in the previous question$)$ and output at potential output $($ $$6$ trillion$).$ However, because the government reneged on its promise last year, workers and firms suspect that the Fed will again shift to an expansionary policy. As a result, in anticipation of the Fed's actions, wage rates and resource prices are negotiated in the expectation of inflation in the current year.

Which of the following most accurately describes the government response to new wage rates and resource price agreements and the long$-$term economic outcome?

The Fed pursues a stable monetary policy, and the economy's output declines.

The Fed once again shifts toward an expansionary policy, and the economy's output returns to potential output.

The Fed shifts toward a restrictive policy, and the economy's output declines.

The Fed once again shifts toward an expansionary policy, and the economy's output declines.

Complete the following table to compare the results of an unanticipated expansionary policy to those of an anticipated expansionary policy in the short run and long run. Determine whether, in the short run, the unemployment rate increases, decreases, or remains unchanged relative to the natural rate when the expansionary policy is anticipated versus unanticipated. Additionally, determine whether, in the long run, the actual price level is above, below, or the same as initial expectations under both scenarios, and, again, determine whether the unemployment rate increases, decreases, or remains unchanged.

Anticipated Expansionary Policy

Unanticipated Expansionary Policy

Short$-$Run Change in Unemployment Rate

Long$-$Run Change in Price Level

Long$-$Run Change in Unemployment Rate