SEMESTER 2 (2017/2018)
TUTORIAL : THURSDAY 10.00-11.00am
Prepared by:
Name Matric Number
Submitted to: Sir Saad Mohd Said
Tutorial Assignment Question (E-Learning)
Explain the concept of rational expectations. How does this view on how expectation are formed differ from the assumption that workers formed expectations of current and future price levels based on past information about prices?
Rational expectations is an economic theory that states that when making decisions, individual agents will base their decisions on the best information available and learn from past event. Rational expectations are the best way to guess about the future. Based on rational expectations, it says that although people may be wrong some of the time, but most of the time (average) they will be correct. The main point is rational expectations assumes that people learn from past mistakes.
The new classical macroeconomics is based on the rational expectations. This means that people have rational expectations about economic variables. The implication is that people make intelligent use of available information in forecasting variables that affect their economic decisions. This implies that people understand how the economy works and how the government policies alter macroeconomics variables such as the price level, the level of employment and aggregate output. Moreover, because of rational expectations, the government cannot fool the people with systematic economic policies.
Rational expectations have implication for economic policy. The impact of expansionary fiscal policy will be different if people change their behaviour because they expect the policy to have a certain outcome. Ratonal expectations implies that the workings of the economy is understood, and the fiscal and monetary policy will be anticipated rendering the policy ineffective.
The rational expectations assumption under new classical view are people are rational. Where there is an adequate information, people form beliefs about the economic future that are reasonably accurate. Moreover, it also based on the judgements, people adjust their economic behaviour accordingly. Last assumption is the markets, including labor markets, are highly competitive. New information is quickly absorbed.

New Classical Model does not accept the Keynesian and Monetarist assumption about backward looking expectations. New classical assumes forward looking or rational means there will be no systematic errors in expectations. The main difference between New Classical with Keynesian and Monetarist is the variables determining the position of labor supply (Ns) and aggregate supply (AS). In Keynesian, labor supply (Ns) is where money wage (W) divided by the expected price level, Ns=(W/Pe). For example, if there is an increase in expected price labor supply (Ns) and aggregate supply (AS) will shift to the left.

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In New Classical, because of rational expectation, labor will make assumption based on the available information and any variable that be affected by the policy. Taking the case of labor in the New Classical Model, under rational expectation is no longer a function of expected real income only. Now the supply of labor would be Ns=t(W/Pe) where t is a given time period, W is the money wage and Pe is the price expectations. It will depend on expected rather than historical prices.

In New Classical, in fact expected price (Pe) depends on the expected level of all components of the model such as expected money supply (Me), expected of government spending (Ge), expected level of tax (Te), expected level of investment (Ie), expected level of tax (Te) and expected level of saving (Se).

In conclusion, the position of aggregate supply (AS) and labor of supply (Ns) is no longer determined by expected price (Pe), but it depends on the expected policy variables. It shows the difference between the New Classical with Keynesian and Monetarist and it formed differ from the assumption that workers formed expectations of current and future prices levels based on past information about prices.

Compare the effect of expansionary monetary policy between the new Classical and Keynesian on output and employment.

Expansionary monetary policy aims to increase aggregate demand (AD) and economic growth in economy. Expansionary monetary policy involves cutting interest rates or increasing the money supply to boost economic activity. Typically this involves a cutting official policy interest rates. Expansionary monetary policy will increase money supply (MS), lower the interest rates (r ) and increase the aggregate demand (AD).

In New Classical

Based on the graph above, it will explain the effect of expansionary monetary policy based on New Classical assumption. When there is an increase in the money supply by the government and assume that there is fully anticipated increase in money supply. An increase in money supply will shift the AD curve to the right from AD0(M0) to AD1(M1). As a result, the output will increase from Y0 to Y1 and price will increase from P0 to P1.
When price increase, the firm will demand for more worker. So the labor demand (Nd) curve will shift to the right from Nd0 (MPN.P0) to Nd1 (MPN.P1). Nominal wages will increase from W0 to W1 and attract more labor to work. Employment will increase from N0 to N1.

Since the position of AS curve is not fixed and the expansionary monetary policy is anticipated, so the level of expected monetary supply will increase. This will increase the expected price level because under rational expectation labor understand there will be an inflationary effect of an increase in money supply. The labor supply curve will shift to the left from Ns0 to Ns1 and at the same time AS curve also shift to the left from AS0 to AS1.
Decline in AS caused the price level to increase from P1 to P2. When price increase again, labor demand curve will also shift to the right again from Nd1(MPN.P1) to Nd2(MPN.P2). In AD-AS diagram , output will go back to original output at Y0 with higher price at P2. Employment also go back to original at N0 but at a higher money wages at W2 in labor market.
In conclusion, with the rational expectation in New Classical, it restore back to initial ouput and employment in short run. In short run, anticipated policy leads to increase in price and money wages but fixed for output and employment level. This is the difference between New Classical in Keynesian in short run because in Keynesian output is fixed because of fixed expected price.

In Keynesian

Based on the graph, it explain the effect of expansionary monetary policy from Keynesian view. When government make an expansionary monetary policy, it will increase the money supply and shift AD to the right from AD0 to AD1. The price will increase from P0 to P1 and output also will increase from Y0 to Y1. When price increase, it will increase the labor demand and shift it to the right from Nd0(MPN.P0) to Nd1(MPN.P1). Because of that employment will increase from N0 to N1 and the money wages also increase from W0 to W1. If expansionary monetary policy is unanticipated, in short run it will only increase price, increase in output and increase in employment. Output and employment will been affected if the policy action in unanticipated. Unanticipated of policy action’s result is same with Keynesian in short run fluctuation.

Assume that the increase in money supply in unanticipated, it will not affect the labor expectations and aggregate price level so Ns and AS will not shift. But in long run, economy is back to the initial level. The employment and output will go back to their original point at N0 and Y0 after adjustment but a higher prive level which means inflation.

As a conclusion, expansionary monetary policy has no effect on New Classical if the policy is anticipated but in Keynesian view, the expansionary policy will increase the output (Y) and employment (N) in short run. Expansionary monetary policy is more effective in Keynesian.