Rational Expectations and
Monetary Policy Ineffectiveness
1. The AS-AD model with rational
expectations
2. Issues of Dynamics Inconsistency
1. The AS-AD model with
Rational Expectations
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Often, the consequences of a policy depend on agents
expectations about the future.
To illustrate the possible ineffectiveness of economic
policy we consider a simple version of Sargent and
Wallace [1976]
→ we assume a AS-AD model and consider a Lucas'
supply function
where
is observed at period t
The case of static expectations
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Consider that expectations are given by
The key point for the result is that expectations are
exogenously given
Combining AS and AD curve implies
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This is a Keynesian type model since the AS curve is
non vertical.
The monetary multiplier is given by
The case of rational
expectations
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We now consider that agents form rational expectations
(they understand the economic model):
To solve the model we: 1) compute the equilibrium in
expected terms in order to determine the equilibrium
value of
2) we solve the equilibrium by taking
into account of the equilibrium value of expected prices.
Step 1:
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By using the expression of the expectation we can
rewite the AS curve as follows:
Only monetary surpises affect output, ie. Anticipated
monetary policy changes are inefficient
→ fluctuations around a vertical AS curve
From Lucas Island to Rational
Expectations in General Equilibrium
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The case with wage rigidities
2. Issues of Dynamics
Inconsistency
The objective of the Central
Bank
Conclusion
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The form of Household's expectations is crucial to
understand the functionning of the economy and
macroeconomic policy
Under rationnal expectations monetary policy is in
general inefficient
→ Neo-classical view of macroeconomic dynamic
→ Inflation bias of the only credible monetary policy of
the central bank (no real effect)
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But considering market imperfections (wage rigidities),
re-introduce a real effect of monetary policy
→ New-keynesian view of macroeconomic dynamic