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

In a new classical model with rational expectations and flexible prices, the central bank announces and then carries out a fully anticipated increase in money supply growth. What is the predicted effect on real output?

Real output shows no systematic change, and the effect falls on the price level. Under rational expectations with flexible prices, agents anticipate the policy and adjust wages and prices immediately. This is the policy ineffectiveness proposition, so only unanticipated monetary surprises can move output away from its natural level.

  1. AOutput rises permanently because demand rises
  2. BOutput rises temporarily and then falls below its natural level
  3. COutput falls because interest rates rise
  4. DNo systematic change in real output; the effect falls on pricesCorrect
  5. Output changes by the size of the money supply increase

Explanation

The policy ineffectiveness proposition says that anticipated monetary policy is built into price and wage expectations at once. Real output stays at its natural level and only the price level moves. Only unanticipated policy can have real effects, and those are temporary.

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