Rational Expectations and Monetary Policy Ineffectiveness

1. The AS-AD model with rational expectations2. Issues of Dynamics Inconsistency

1. The AS-AD model with Rational Expectations

● Often, the consequences of a policy depend on agents expectations about the future.

● To illustrate the possible ineffectiveness of economic policy we consider a simple version of Sargent and Wallace [1976]→ we assume a AS-AD model and consider a Lucas' supply function

where is observed at period t

The case of static expectations● Consider that expectations are given by● The key point for the result is that expectations are

exogenously given● Combining AS and AD curve implies

● This is a Keynesian type model since the AS curve is non vertical.

● The monetary multiplier is given by

The case of rational expectations

● We now consider that agents form rational expectations (they understand the economic model):

● To solve the model we: 1) compute the equilibrium in expected terms in order to determine the equilibrium value of 2) we solve the equilibrium by taking into account of the equilibrium value of expected prices.

● Step 1:

● By using the expression of the expectation we can rewite the AS curve as follows:

● Only monetary surpises affect output, ie. Anticipated monetary policy changes are inefficient→ fluctuations around a vertical AS curve

From Lucas Island to Rational Expectations in General Equilibrium

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The case with wage rigidities

2. Issues of Dynamics Inconsistency

The objective of the Central Bank

Conclusion● The form of Household's expectations is crucial to

understand the functionning of the economy and macroeconomic policy

● Under rationnal expectations monetary policy is in general inefficient→ Neo-classical view of macroeconomic dynamic

→ Inflation bias of the only credible monetary policy of the central bank (no real effect)

● But considering market imperfections (wage rigidities), re-introduce a real effect of monetary policy→ New-keynesian view of macroeconomic dynamic