Concepts
- Rational Expectations
- Inflationary Expectations
- Double Shift in AD-AS Model
- Expansionary Policy Leads to Inflation (Rightward Shift in AD)
- Inflation Reduces the Purchasing Power (Real Value) of Wages
- This Makes Workers Upset
- Workers Demand Higher Wages
- Becomes More Difficult for Businesses to Produce (Leftward Shift in SRAS)
- In the End, Inflation Increases while RGDP/Unemployment have No Change
- Nominal Values Increase as a Result of Inflationary Expectations
- Real Values Remain Unchanged as a Result of Inflationary Expectations
- Inflationary Expectations Causes a Negative Supply Shock
Overview
Rational Expectations is a theory that says people use all available information to anticipate changes in the economy (most notably, changes to inflation). It is a theory held by classical economists used to rebut the effectiveness of Keynesian recommended expansionary policies. The most common application of this theory deals with inflationary expectations. It says that when people fully anticipate an expansionary policy it will only lead to an increase in inflation with no change to real output. This happens because if the FED and/or the government announces an expansionary policy, workers anticipate that higher inflation will result (due to the increase in AD). This inflation leads to their wages losing purchasing power (real value). This upsets workers (especially union workers) and causes them to demand higher wages (to keep pace with inflation). This increase in wages makes it more difficult for businesses to produce, and results in a leftward shift in SRAS. The increase in production from the expansionary policy gets offset by the decrease in production from the decrease in aggregate supply. The only lasting impact is the higher price level brought forth by both of these changes.
Materials
Lecture
Video Coming at Later Date
Quiz
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