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IAI Actuarial Core Principles · Economic Modelling · Rational expectations theory and the efficient markets hypothesis

An economy has an announced and fully credible monetary expansion. Under rational expectations with flexible prices and wages (the policy ineffectiveness proposition), what is the expected effect on real output?

Real output is unchanged. With rational expectations and flexible prices, agents foresee the inflationary effect of an announced credible expansion and raise prices and wages immediately, so only the price level changes. Only unanticipated policy surprises can move real output.

  1. AReal output rises permanently because money supply has increased
  2. BReal output rises temporarily and then falls below its original level
  3. CReal output is unchanged because agents anticipate the price effect and adjust immediatelyCorrect
  4. DReal output falls because agents expect higher interest rates
  5. Real output changes in proportion to the money supply growth

Explanation

If the policy is anticipated, agents build the resulting inflation into wages and prices straight away. Real variables therefore do not move, and only the price level changes. Only unanticipated shocks can affect real output in this framework.

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