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1. Learning Outcomes
After studying this module, you shall be able to
To understand the role of economic policy by introducing uncertainty in the model.
To understand the formulation of expectations of inflation.
To know about Rational Expectation framework to incorporate expectation
To identify the policy effectiveness in case rational expectation
To know about Adaptive Expectation of inflation.
To explore the possibilities policy effectiveness in Adaptive expectation.
2. Introduction
In the earlier module you have seen the dynamics of inflation in aggregate demand AD and
aggregate supply AS , thus describe the mechanism by which long run equilibrium and stability
and equilibrium is attained .You have also gone through the implications of demand side shocks
and supply side shocks.
It has been observed that both the Aggregate Demand and Aggregate Supply Schedules under
dynamics of inflation are vulnerable to demand side and supply side shocks which in turn affect
the equilibrium level of inflation and income. As a result there exists a tremendous role of
economic policy in order to conduct a meaningful analysis by introducing element of uncertainty
in the model.
Since we need to model uncertainty, one needs to define and formulate expectations about
inflation. The notion of Rationality would require individuals using the information in an optimal
manner , such type of expectations are referred to as Rational Expectations .In this version of
model , the policy is unable to maintain equilibrium in the economy in the situation of any shocks
.
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There are cases when effectiveness of Monetary policy is enhanced which results in an anti-
inflationary measure .The new Keynesian Model brings about a notion of Adaptive Expectations
.Adapting this notion of expectations, the policy change would be successful in influencing the
the individuals conceal their information.
This module would explore the role of economic policy in affecting the equilibrium levels of
inflation and income .The module will describe the ways of formulating expectation about
inflation in form of Rational Expectations and Adaptive Expectations and discuss policy
ineffectiveness in both the cases.
3. Role of Economic Policy in Generalized Model
The dynamic model incorporating inflation in AD aggregate demand and AS aggregate supply
have expected inflation , therefore in order to build up a meaningful analysis to establish the role
of government and economic policy we have to introduce uncertainty into the model .
The Goods Market Equilibrium: IS curve
Eq (1)
The Money Market Equilibrium: LM curve
Eq (2)
The error terms added to the IS g m .
These random error terms are assumed to white noise implying zero mean value and uncorrelated
random variables i.e.
E g m g m )=0
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The dynamic aggregate supply curve can be affected by introducing productivity shocks into the
labor demand equations as
Eq (3)
s is the shock to the real wages. This has the same effect on the demand for labor as an
equal proportional decline in real wages .Taking the labor demand prior to the shock
Eq (4)
Taking the difference between the two periods we get
Eq (5)
w-1 p-1 . By substituting for n of eq (5) in the aggregate supply
8 6 s we get
ys = y-1s 6 10 - s s
e
- 4 6 10 .Hence aggregate supply schedule is given
by
ys = ye 4
e
- s s Eq (6)
3.1 Economic Policy Implications
When there is an increase in value of stochastic var g , implying any change in Fiscal Policy
,shifts the IS curve outwards whereas a decrease will shift the IS curve inwards .as shown in
figure ( 1 ) .
ECONOMICS Paper 4: Basic Macroeconomics
Module 35: Dynamics in AD -AS Model: Formulation of Policy and
Expectation
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FIGURE 1
m will shift the LM schedule outwards and a decrease will shift it inwards.
Therefore any disturbance which shifts IS- LM curve outwards shifts AD curve outwards and any
disturbance which shifts IS LM curve inwards will shift AD curve inwards .as shown in figure
( 2) and figure (3)
FIGURE (2)
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FIGURE (3)
3.2 Supply side Shock
e
In the long , the long run supply schedule shifts because of change in
s but in the short run
supply schedule as depicted in the figure ( 4 )
FIGURE ( 4)
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4. Aggregate Demand Schedule: A Stochastic Version
The aggregate demand schedule is derived by substituting IS curve of eqn( 1 ) in LM curve in eq
(2) . This AD curve can be written as
Eq (7)
The values are not directly observable even after the fact because the data do not
distinguish between anticipated and unexpected events.
4.1 Shifts inthe Stochastic Version of AD schedule:
g m s g , will shift IS outwards and
m will shift LM curve outwards and AD schedule outwards implying that income
and inflation will rise and interest will fall.
growth of real cash balances for given µ. Therefore LM model will shift outwards and therefore
AD . As a result income will rise and inflation and interest rate will fall
ECONOMICS Paper 4: Basic Macroeconomics
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FIG (5) a, b, c , d
ECONOMICS Paper 4: Basic Macroeconomics
Module 35: Dynamics in AD -AS Model: Formulation of Policy and
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Module 35: Dynamics in AD -AS Model: Formulation of Policy and
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5. Rational Expectation
It is important to distinguish between the short-run and long-run supply schedules. In the short
run, actual inflation may deviate from expected inflation whereas in long run actual inflation is
e
equal to expected inflation. This implies . This signifies the fact that the process of
expectations formation is an extremely important factor in models of macroeconomics. Since
expected values are not observed directly one needs to theorize about them. Individuals are
expected to use the information they have about the economy in an optimal manner. This concept
ECONOMICS Paper 4: Basic Macroeconomics
Module 35: Dynamics in AD -AS Model: Formulation of Policy and
Expectation
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is known as concept of Rationality .Forming expectations using this concept of rationality is
called Rational Expectations.
Economic agents are aware of and use optimal means of information, this means the following,
1. The economic agents know IS-LM-AS Model and know that a fall in consumption
expenditure will cause aggregate demand AD to fall and further lead to fall in inflation .As
inflation declines, the expected inflation in the long run would also fall .This results in drop
e
in real interest rates ( i- ) . IS and AD schedule will shift outwards. This would imply that
the drop in the inflation is only temporary.
2. Individuals have some information about current performance of the economy and policies
which they would use in forecasting inflation .By solving IS-LM-AS model to obtain
exogenous variables in the system of AS - AD equations .
By solving AD
Eq(8)
Rational Expectation implies that individuals know the cause of inflation .An increase in
e
consumption expenditure is caused by increase 0
expected inflation increases inflation .In order to ensure that inflation does not increase more than
3<1 on the
3 . This is going to lead to an explosive cycle of inflation merely through the
e
0
responds so expected inflation cannot remain at same level , as a result there exists a vicious cycle
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e
. The model treats expected inflation as endogenous now instead of
exogenous variable.
Eq (9)
where the s are undetermined since now we treat expected inflation is endogenous .Expected
e
in is nothing but mathematical expectation .
Eq (10 )
These terms disappear as the expected value of all the random error terms
are zero.
e
Substituting expression for expected inflation from the
exogenous variables .The final equation for inflation is as follows.
e e
We can now substitute this expression of into Eq (8) and thus eliminate from the list of
exogenous variables. This produces
Eq (11)
By a careful comparison it can be seen that equation Eq (11) has exactly the same variables on the
right-hand side as Eq (9), the one that each individual invents when forming expectations about
e
. Since they come from the very same IS-LM-AS model, the coefficients attached to each
variable must be the same. With this information we can now solve for the undetermined
coefficients, the s in Eq (9), by setting each of them equal to the corresponding coefficient in
Eq (11) and solving for the s. Thus we have
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which simplifies to 0 = 1/(1 3). This parameter is positive since it was assumed earlier that 0
< 3< 1. Next we have
which again simplifies to 1 = 1/(1 3) > 0. Similarly 2 = 1/( 1 + 3 4 + 1 2 4) > 0 and
<0
The undetermined coefficients are now determined and it is possible to get rid of the s in Eq (9)
which now represents a structural relationship for the inflation rate, including the rate of expected
e
inflation, but without having as a variable on the right-hand side. By substituting for the Eq (9)
we arrive at
Eq(12)
Taking expectations of inflation in equation (3.39) we have
Eq(13)
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Eq(13) differs from Eq(12) only to the extent that E( m) = E( g) = E( s) = 0. This completes our
examination of the process by which expectations about inflation are formed by rational
individuals who use all available information
6. Aggregate Supply Schedule: A Stochastic Version
The aggregate supply schedule in Eq (3) is given as
ys = ye 4
e
- s s
In the above equation there are two sources of change in Income Y
e
(a)
(b) Non- s
Substituting Eq(12) and Eq(13) in the above aggregate supply equation we get
Eq(14)
When m, g or s take on positive or negative values then y deviates from y eHere s appears twice,
once with a minus sign and once with a positive sign. On the one hand, s> 0 improves the
marginal product of labor directly and therefore increases y, but on the other hand it also lowers
e
below and, hence, reduces y. The net effect, however, is positive: y increases by [( 1 +
1 4)/( 1 + 3 4 + l 2 4)] s.
6.1 Policy Ineffectiveness
New Classical framework renders stabilization policy of government ineffective .This can clearly
e
be shown using the above equations .Let us now examine the difference between and by
ECONOMICS Paper 4: Basic Macroeconomics
Module 35: Dynamics in AD -AS Model: Formulation of Policy and
Expectation
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examining Eq(12) and Eq(13). We observe that (i) a change in a predictable or deterministic
exogenous variable such as , 0 or ye has exactly the same effect on and e
and (ii) random
events such as m, g or s affect but not expected inflation. The difference between inflation
e
and expected inflation is the error that individuals make in forming expectations. The above
analysis suggests that there is nothing systematic about these differences, these are entirely
random. The policies are ineffective and do not possess any advantage over rational individuals in
predicting inflation .Therefore the policy ineffectiveness in maintaining equilibrium in the
economy at the times of exogenous shock or to reduce unemployment is clearly established .
6.2 Anti Inflationary Policy
While in the New Classical model there exists active stabilization policy ineffectiveness , there is
strong existence of effectiveness of monetary policy as an anti inflationary measure .It is clearly
observed from the above analysis that the economy can be in the equilibrium at any rate of
inflation .
FIG ( 6 )
In order to make an attempt to reduce the rate of inflation permanently, the central banks must
reduce rate of growth of money supply. Assume that central bank implements the policy of
reducing the rate of growth of money
e
by 1/( 1 3 ) times the change in µ according to Eq ( 12 ) and
Eq( 13 ) . As a result economy will remain on the vertical line y e. By reducing the rate of growth
of money supply from µ0 to µ2 , AD curve shifts to AD' , inflation would overshoot its final target
ECONOMICS Paper 4: Basic Macroeconomics
Module 35: Dynamics in AD -AS Model: Formulation of Policy and
Expectation
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and would consequently shift the AD schedule from AD' to AD'' . Thus moving the equilibrium
from E' to E'' as in the above fig (5 ) .
e
There can arise a case wher could not adjust to lower rate of money growth
µ . This could be because workers were under the notion that central bank announcement of
policy was the way of making them accept the lower real wages. In such case they continue
bargaining for wages . As a result AS schedule will not shift while
AD would establish equilibrium at E'' .Therefore it can be observed that Monetary Policy not only
e
and greater the credibility of central bank of the
country the greater is the ability to affect inflation or reduce inflation .
7. Adaptive Expectation: The New Keynesian Model
One prominent feature of differences between New Classical and New Keynesian schools of
thought is the process of expectations information. The New Classical model, almost all the
markets clear all the time and instantaneously. New Classical analysis is based on the rational
expectation while New Keynesian school argues that the expectations are adaptive in nature. This
would suggest that if are known today and we can use this
information to calculate 1. This implies that all the information about the economy that is
currently available is used as a predictor of in the current period. Such an expectation is referred
to as Adaptive Expectation. Thus the following expectations process is applicable:
. Eq ( 15 )
ECONOMICS Paper 4: Basic Macroeconomics
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The parameters attached to the 1 variables are determined in the manner of Eq ( 8 ) which shows
e
how s change that is how random shocks affect inflation. For example, if m 1> 0, should be
lower than 1 because the inflationary shock is not expected to last.
e
Adaptive expectations lead to systematic errors in expected inflation because will always be
below when inflation is rising and it will be above when inflation is falling; only when
e
inflation is steady , expected inflation is equal to inflation i.e. equal . Although individuals try
to eliminate such errors they cannot prove their performance since they are not aware of the
parameters which are yet to be measured.
FIG ( 7 )
An economy operating with adaptive expectation as expressed by Eq (15) can move away from
equilibrium although only temporarily. Assume there is an increase in rate of money supply µ.
AD curve shifts up by increase in µ, a new equilibrium is established at Since inflation also
e
1 AS curve also shifts up to AS' shifts AD schedule up by 3. Since rate
of growth of money supply is more than the inflation, m p has increased and this puts pressure
on AD schedule by shifting it further to AD'' so that a new equilibrium is established at In
such case equilibrium real output y can be higher or lower than at E'. As a result AS and AD keep
e
. In this process policy change has
ECONOMICS Paper 4: Basic Macroeconomics
Module 35: Dynamics in AD -AS Model: Formulation of Policy and
Expectation
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been able to influence income and unemployment rate by lowering the real wages during the time
when expected inflation responds to change with the time lag involved .This clearly shows that in
the Adaptive Expectation framework, government is able to exploit and lowers real wages
affecting income and unemployment .This would further compel the individuals to conceal the
information.
ECONOMICS Paper 4: Basic Macroeconomics
Module 35: Dynamics in AD -AS Model: Formulation of Policy and
Expectation
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8. Summary
1. It has been observed that both the Aggregate Demand and Aggregate Supply Schedules
under dynamics of inflation are vulnerable to demand side and supply side shocks which
in turn affect the equilibrium level of inflation and income.
2. The dynamic model incorporating inflation in AD aggregate demand and AS aggregate
supply have expected inflation , therefore in order to build up a meaningful analysis to
establish the role of government and economic policy we have to introduce uncertainty
into the model .
3. In the short run, actual inflation may deviate from expected inflation whereas in long
e
run actual inflation is equal to expected inflation. This implies . This signifies the
fact that the process of expectations formation is an extremely important factor in models
of macroeconomics.
4. Individuals are expected to use the information they have about the economy in an
optimal manner. This concept is known as concept of Rationality .Forming expectations
using this concept of rationality is called Rational Expectations.
5. New Classical framework renders stabilization policy of government ineffective. The
policies are ineffective and do not possess any advantage over rational individuals in
predicting inflation .Therefore the policy ineffectiveness in maintaining equilibrium in
the economy at the times of exogenous shock or to reduce unemployment is clearly
established.
6. While in the New Classical model there exists active stabilization policy ineffectiveness,
there is strong existence of effectiveness of monetary policy as an anti inflationary
ECONOMICS Paper 4: Basic Macroeconomics
Module 35: Dynamics in AD -AS Model: Formulation of Policy and
Expectation
