MEC 531 Presentation 1

Group

Presentation By:

The

General (kelvintaps@gmail.com), Leonard

(mlusai2001@gmail.com) and Precious
(peemukaira@gmail.com)

Compare

and Contrast Monetarists and

Rational Expectations Views to Demand
Management Policies, in particular their
perspectives on Monetary Policy.

Monetarists vs. Rational Expectations:

Views on Monetary Policy
Demand

management refers to the art or

science of controlling aggregate economic
demand, through the use of Monetary and
Fiscal Policies, to avoid recession.
Effectiveness of Demand mgmt policies differ
with different schools of thought.
This presentation takes a comparative and
contrasting analysis on the Monetarists and
Rational Expectations regarding demand
mgmt policies, focusing particularly on the
Monetary Policy

Overview of the Schools

Monetarists
Milton

Friedman has been the leading spokesman for

monetarism over the last few decades.
The main message of monetarists is that money
matters.
Monetarism, however, is usually considered to go beyond
the notion that money matters.
The monetarist analysis of the economy places emphasis
on the velocity of money, or the number of times a
dollar bill changes hands, on average, during a year; the
ratio of nominal GDP to the stock of money (M):

The Quantity Theory of Money

If

there is equilibrium in the money

market, then the quantity of money
supplied is equal to the quantity of money
demanded. When M is taken to be the
quantity of money demanded, this
equality would make the quantity of
money demanded dependent on nominal
GDP, but not the interest rate.

Inflation as a Purely
Monetary Phenomenon
Inflation

is always a monetary
phenomenon inflation is always
and everywhere a monetary
phenomenon
If the money supply does not change, the
price level will not change.
The view that changes in the money
supply affect only the price level, without
a change in the level of output, is called
the strict monetarist view.

Inflation as a Purely
Monetary Phenomenon contd
Most

monetarists argue that inflation

in the United States could have been
avoided if only the Fed had not
expanded the money supply so rapidly.
Most monetarists do not advocate an
activist monetary policy stabilization
expanding the money supply during
bad times and slowing its growth
during good times

Inflation as a Purely
Monetary Phenomenon
Time lags are

the most common

argument against such management.
To this end, Monetarists advocate a
policy of steady and slow money
growth, at a rate equal to the average
growth of real output (Y).

Policy Implications
They

argue that Fiscal Policy is often a

bad policy, where FP could be beneficial,
Monetary Policy can do the job better
The use of FP results in crowding out
effect which pushes the real interest
rates and is also likely to be inflationary.
As such, MP should be used mainly for
stabilization policy

New Classical Macroeconomics

On

the empirical level, new classical

theories were an attempt to explain the
apparent breakdown in the 1970s of the
simple inflation-unemployment tradeoff predicted by the Phillips Curve.
On the theoretical level, new classical
macroeconomists argue that traditional
models have assumed that expectations
are formed in naive ways.

New Classical Macroeconomics

contd
Naive

expectations are inconsistent

with the assumptions of
microeconomics. If people are out to
maximize utility and profits, they
should form their expectations in a
smarter way.
Resultantly, the notion of Rational
Expectations emerges.

Rational Expectations
Hypothesis (REH)
Rational

expectations is the main component

of new classical macroeconomics
Introduced by John Muth (1961):
Economists should be more careful about their
informational assumption, in particular about the
ways, the expectations are formed.
expectations, since they are informed
predictions of future events are essentially the
same as predictions of the relevant economic
theory.
Econometrica (1961): Rational Expectations and
the Theory of Price Movements

Rational Expectations
Hypothesis (REH)
A

number of Economists Thomas

Sargent, Neil Wallace and Robert E.
Lucas also used it to explain certain
aspects of Macroeconomics.
Lucas became popular and won a
Nobel Prize for his work

Rational Expectations contd

The

rational-expectations hypothesis assumes

people know the true model of the economy and that they
use this model to form their expectations of the future.
By true model we mean a model that is on average
correct in forecasting inflation.
Therefore, increasing inflation would lead to a rational conclusion
that the Federal Reserve will engage in restrictive monetary policy
to reduce inflationary pressure
Such expectations would be considered rational because
they include information that is relevant for properly
forecasting inflation
People

are said to have rational expectations if they use

all available information in forming their
expectations.

Rational Expectations
Hypothesis (REH)
Because there

are costs associated

with making a wrong forecast, it is not
rational to overlook information, as
long as the costs of acquiring that
information do not outweigh the
benefits of improving its accuracy.

Rational Expectations
and Market Clearing
When

expectations are rational,

disequilibrium exists only temporarily
as a result of random, unpredictable
shocks.
On average, all markets clear and
there is full employment. There is no
need for government stabilization.

Anticipated Versus
Unanticipated Monetary Policy
Rational expectations

combined with
flexible prices and wages concludes
that anticipated monetary policy will
not impact economic activity

Unanticipated MP
Assume

money growth is not

anticipated
Increased aggregate demand leads to
higher prices that are not anticipated
Wages will lag prices and business firms
hire more workers to expand output
Result is higher output and lower
unemployment when money supply
growth is not anticipated

FIG.1 Anticipated monetary policy shifts aggregate supply

along with aggregate demand, leaving GDP unchanged .

Implications for Stabilization Policy

Stabilization

policy usually falls under the

category of anticipated policy
Therefore, it is generally correctly
anticipated through rational expectations
Systematic policies are useless
Because of rational expectations, only
erroneous (completely unanticipated)
changes in the money supply influence the
level of economic activity

Implications for Stabilization Policy

contd
This suggests

that the debate between

rules versus discretion is
irrelevant, neither policy employed by
the Federal Reserve can influence real
economic activity
The outcome of the rational
expectations world is decidedly
classical-Monetarist rather than
Keynesian

SIMILARITIES
1.

Variations in Money are

inflationary

The

new classical models (REH) developed by Sargent and

Wallace (1975) , incorporated Friedman`s view that anticipated
variations in money led simply to changes in prices.

2.

Use of Rules

Rationalists

and monetarists both agree on the use of

rules as opposed to the use of discretion in
implementing the monetary policy.

SIMILARITIES CONTINUED
3.

Market Clearing

They

both agree that markets will clear and participants

have rational expectations.
If firms have rational expectations, on average, prices
and wages will be set at levels that ensure equilibrium
in the goods and labor markets. In other words, on
average, there will be no unemployment.
When expectations are rational, disequilibrium exists
only temporarily as a result of random, unpredictable
shocks.
On average, all markets clear and there is full
employment. There is no need for government
stabilization.

SIMILARITIES CONTINUED
4.

The Economy is naturally

stable, unless disturbed by erratic
monetary shocks
In line with the monetarist school,
Rationalists believe that the economy is
inherently stable, unless disturbed by
erratic monetary growth, and that when
subjected to some disturbance, will
quickly return to its natural level of
output and employment.

5.

No trade off between inflation and UE

(assuming rational expectations)
They both agree that there is no trade off
between inflation and unemployment (differing
only on the time periods)
Monetarists argue that there is no trade off in
the long run, as people would have adjusted for
expectations, but, at least in the short run thus
the Expectations-Augmented Phillips Curve.
For Rationalists, there is NO such trade off even
in the short run.

DIFFERENCES
Noteworthy

is that the two schools

hold almost the same views on MP,
the only differences being that of
emphasis.
For instance, Rationalists break their
analysis, into Anticipated vs.
Unanticipated whereas, Monetarists
did not go that step further.

1. Inflation, The Phillips Curve,

and Credibility
On

one hand, the Monetarists argue that there is

unemployment-inflation trade off at least in the short
run, while on the other, the rationalists challenge that
this trade off does not even exist.
Explanation
With an upward sloping aggregate supply curve,
policymakers could increase the level of economic
activity and reduce unemployment as long as they
were ready to tolerate an increase in inflation
Monetarists argue that in the short-run this might be
so, but after expectations have adjusted, the aggregate
supply curve is vertical with no permanent trade-off

Inflation, The Phillips Curve,

and Credibility (Cont.)
Rational

expectations theory pushes the

monetarists long-run analysis into short
run by transforming a series of upwardsloping aggregate supply curves into a
vertical one.
This condition, which is shown in Fig 2,
demonstrates that simultaneously
shifting the aggregate supply and
demand curves, economy remains at
natural full employment level, YFE, at
increasingly higher prices

FIG 2 Anticipated monetary policy can

affect only the price level.

2. Interest Rates and Anticipated

Monetary Policy
The

rational expectations message for

interest rates is not much brighter
than for countercyclical policy in
general
The Monetarists acknowledge an
increase in the money supply might
temporarily reduce interest (liquidity
effect), however, inflationary
expectations will ultimately drive
nominal rates above real rates

Interest Rates and Anticipated

Monetary Policy (Contd)
With

rational expectations, an anticipated

increase in the money supply immediately
leads to higher nominal interest rates
The only way that monetary policy can
reduce interest rates in the short-run is to
have a completely unexpected expansion
in the money supply (again the emphasis,
here, is that the effectiveness of MP depend
on whether its anticipated or unanticipated)

Rules for MP are effective, but

Although

they both agree that

discretionary policies do not work, the
rationalists go further emphasizing the
importance of credibility and time
consistency in policy implementation.
For Rationalists, the effectiveness of
rules depend on the institutional
credibility, thus policy makers should (i)
Announce, (ii) Implement, faithfully and
(iii) Avoid shifting policies abruptly.

Rules for MP are effective, but

They believe,

therefore, that such

procedure, will create long term
steady economic growth and high
employment.

References

Muth,

J.F. (1961), Rational Expectations

and the Theory of Price Movements,
Econometrica, July.

Snowdon,

B. and Vane, H.R. (2005),

Modern Macroeconomics Its Origins
Development and Origin and Current
State, Edward Elgar Publishing Limited,
UK

END

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