ECON 2450 Chapter Notes -Adaptive Expectations, Phillips Curve, Rational Expectations

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It would raise inflation, and raise the price level. Suppose half the contracts are signed at the beginning of the period and half the contracts in the middle of the period. In the figure below the initial full employment equilibrium is at point a, with the monetary policy reaction function at mpfr0 and the phillips curve at. The announcement of the policy will affect labour contract negotiations in the middle of the period. As a result in the middle of the period wages will increase by a very small amount, and the phillips curve will shift up by a small amount, to pc1. The reduction in r* will also shift up the monetary policy reaction function to mprf1. The equilibrium in the second half of the period will be at point b. Hence, the anticipated expansionary policy will reduce the unemployment rate even though expectations are rational. Policy exercise 6: in year zero, actual inflation is equal to expected inflation.

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