Question

Suppose policy markets use monetary policy in an attempt to keep unemployment below its natural rate.

(a) Use the Lucas misperceptions model or the Keynesian fixed wage model to explain why such a policy is most effective when it is not anticipated.

(b) Can the policy be expected to keep unemployment below its natural rate (i.e. full employment rate) in the long-run?

(c) Using the expectations-augmented Phillips curve, explain why continuous use of such a policy leads to ever-accelerating inflation.

(d) If policy markets have this incentive to keep unemployment below its natural rate, can you provide one measure that can result in a long-run low-inflation equilibrium?

Answer 1

a. Monetary policy would involve cutting interest rates. Lower rates decrease the cost of borrowing and encourage people to spend and invest. This increases AD and should also help to increase GDP and reduce demand deficient unemployment. ... This is an attempt to increase the money supply and boost aggregate demand.

Lucas Misperceptions Approach to AS-AD

the short-run:  brief enough time period such that decision makers don’t have time to fully adjust to unexpected changes.  Expectations are fixed.

long run: decision makers fully adjust, expectations are not fixed.

So when the monetary policy is not anticipated , the unanticipated rise in AD, due to say a fall in rate of interest.

a fall in r leads to a rise in AD . Since expectations are fixed there is movement along the AS curve resulting in Increased Output and thus employment.

b.

In the long run, expectations adjust.  Workers realize that though employment has gone up there has been a rise in the price level which has adjusted from p₀ to p1 and they adjust their wage expectations accordingly and thus AS shifts back and to the left.

Long-run aggregate supply is at Q_p as was the case originally.