[...]... expectation of Pt: Et-lPt = Et-1 [ao - bo - hiP; - - (- 191 al 64 - bo) (b 1 ) /Pt ai al (ao - bo al + where P I, (ao - bo), no stochastic elem,: Pt fluctuates randornt -( 1/ai)Ut , and exhi' so that agents do supply shock, for ex What would have be tational errors do dis1 says that the expect, actual price level and I Pre = XPt_i + (1 - I By using (3.6) and (3 Pt - (1 - ))Pt-1 C.* — al x(a o Uti 1 - (—)... words of Sa system, there is - lical policy To exploit die ,umption pt = : : • _ employ and expec • authority cannot expk Chapter 3: Rational Expectations and Economic Policy their motivation from Economic Association, and 4,-r the REH war model, that is based on Second, we take expectations of p t , conditional on the information set Qt-i Et-iPt = Po - ao + PiEt-i nit + ai + /32Et-iEt-i [Pt+i - Pt]... Economic Policy P- I The purpose of this chapter is to discuss the following issues: 1 What do we mean by rational expectations (also called model-consistent expecta tions)? 2 What are the implications of the rational expectations hypothesis (REH) for the con duct of economic policy? What is the meaning of the so-called policy-ineffectiveness proposition (PIP)? - 3 What are the implications of the REH for... the effectiveness of monetary policy whatsoever How do we solve the model given in (3.14 )-( 3.16)? It turns out that the solution method explained above can be used in this model also First, we equate aggregate supply (3.14) and demand (3.15) and solve for the price level: , Et-ipt , - = 1 F obtained: So - ao + I3imt +aiEt-iPt + /32Et-i [Pt+i - pd + vt — ut al + 8 , 68 (3.L 1 Pt - Et- t unanticii ' =... which they can sell their goods They make this decision on the basis of all information that is available to them In the context of this model, the information they possess in period t - 1 is summarized by the so-called information set, Qt-i 2 t -1 {Pt -1 ,Pt -2 , Qt Qt- _2, ;ao, ai, daptive luces a higher price level wage, employment, and -cant role In a macroeLich as fluctuation in the , n reunification,... Foundation of Modern Macroeconomics Of course, the PIP caused an enormous stir in the ranks of the professional economists Indeed, it seemed to have supplied proof that macroeconomists are useless If macroeconomic demand management is ineffective, then why should society fund economists engaging themselves in writing lengthy scholarly treatises on the subject of stabilization policy? On top of this came... are, of course, known Agents know past observations on Qt _ i and Pt _i, and can use the model (3.1 )-( 3.3) to find out what the corresponding realizations of the shocks must have been (i.e Ut_i) The REH can now be stated very succinctly as: Pt = E [Pt I Qt_i] (3.5) 63 The Foundation of Modern Macroeconomics but the REH states in coinc expectation, L.c solution for Pt = 0 -0 0 where E t _1 is short-hand... correct amount of labour As a result, the economy jumps from E0 to E1, output is equal to Y* and the price level is P i Of course, this adjustment story amounts to the PFH version of the policy-ineffectiveness proposition Since there is no uncertainty in the model, forecasting is not difficult for actual price The Foundation of Modern Macroeconomics market is describe I Q4D = ao _ Pe P Qs = bo -r k (215... interpretation of the error term in the money supply rule is not that the monetary authority deliberately wishes to make the money supply stochastic, but rather that she has imperfect control over this aggregate We could also allow money supply to depend on other elements of the information set, i.e pt i, Pt-2, • • •1 Mt-2, Mt-3, • • • , Yt-2, Yt-3, • , but that does not affect the qualitative nature of our... value of zero (EUt = 0), no autocorrelation (EUt Us = 0 for t s), and a constant variance of a 2 E(Ut - EUt) 2 ], where E(.) is the unconditional expectations operator This distributional assumption is written in short-hand notation as N(0, a 2 ) Recall from first-year statistics that the normal distribution looks like the symmetric bell-shaped curve drawn in Figure 3.3 Fourth, past realizations of the . available Library of Congress Cataloging in Publication Data Heijdra, Ben J. Foundations of modern macroeconomics / Ben J. Heijdra, Frederick van der Ploeg. p. cm . Includes bibliographical references. 1. Macroeconomics. . 2002  339—dc21  2001055718 ISBN 0-1 9-8 7761 8-7 ISBN 0-1 9-8 7761 7-9 (pbk.) 10 9 8 7 6 5 4 3 2 1 Typeset by Newgen Imaging Systems (P) Ltd, Chennai, India Printed in Great Britain on acid-free paper by T.J. International. (intermedi- ate) macroeconomics course whilst Chapters 1 2-1 7 are aimed at final-year advanced undergraduates. For example, we have ourselves used Chapters 1-1 0 in our second- year macroeconomics