Inflation-unemployment trade-off under rational expectations, Microeconomics

Inflation-Unemployment Trade-off under Rational Expectations:

Robert Lucas (1972) pointed out another implication of the above hypothesis of adaptive expectations. Suppose in a particular period (say period 0) the unemployment rate is lower than the natural rate. Then Φ(0), the actual rate of inflation in period 0 must have been greater than Φe(0), the rate of inflation expected by workers. Now suppose that the rate of growth of nominal demand is such that over time there is a constant rate of inflation Φ(0). Then, from (5.5) it follows that for all t≥0, 

1116_InflationUnemployment Tradeoff under Rational Expectations.png

363_InflationUnemployment Tradeoff under Rational Expectations 1.png

That is, if the expected rate of inflation is less than the actual rate of inflation in mod 0 it will continue to be so in all future time periods even though the difference between the two rates converges to 0 as t->∞.

The implication is that together with a constant rate of inflation, the economy can have a rising rate of unemployment (because the difference between the actual rate of inflation and the rate of inflation expected by workers diminishes over time) but the rate of unemployment can still be lower than the natural rate in every time period (because the actual rate of inflation is always greater than the rate expected by workers). That is over the long run, together with a constant rate of inflation, the economy could still have an average rate of unemployment lower than the natural rate.

Moreover, the above solution also implies that ceteris paribus the greater the value of Φ(0), the greater would be the derivation the actual from the expected rate of inflation in any time period. Therefore, the greater would be the deviation of the actual rate of unemployment from the natural rate in any time period. Hence, the higher the constant rate of inflation in the economy, the lower would be the long-run average rate of unemployment.

This implies that while macroeconomic policy cannot achieve a constant and permanently lower rate of unemployment in an anomy by choosing a constant but permanently higher rate of Won, an inflation-unemployment trade-off still exists. By choosing a constant but permanently higher rate of inflation policy makers can still -achieve a permanently lower rate of unemployment in each period resulting in a lower long-run average rate of unemployment.

 

 

 

 

Posted Date: 11/21/2012 7:46:40 AM | Location : United States







Related Discussions:- Inflation-unemployment trade-off under rational expectations, Assignment Help, Ask Question on Inflation-unemployment trade-off under rational expectations, Get Answer, Expert's Help, Inflation-unemployment trade-off under rational expectations Discussions

Write discussion on Inflation-unemployment trade-off under rational expectations
Your posts are moderated
Related Questions
Suppose a firm faces two markets for the same product. In market A, the demand function is PA=60-QA, while in market B the demand function is PB=36-0.5QB. The total cost function i

At what point is the Fed likely to raise interest rates for the first time? How large are the first couple of hikes likely to be? (hints: conditional on unemployment or gdp growth

How can we identify that something is elastic or inelastic?  When demand of any commodity does not change with the change in price of that commodity that item is said by inelas

What is use of analytical tools in the modern economics? Analytical Tools: Modern economics also gives different powerful analytical tools which are usually specified by geo

In this section, we ask you to write down a simple, formal, mathematical model. A small number of points will be awarded for an intuitive discussion of the problem, but most of the

Marketing Economies: These are derived from the bulk purchasing of inputs and bulk distribution of outputs. A large firm is able to buy its raw materials in larger quantities

what are the practical importance of income elasticity of demand?

Interest: A lender charges interest as the price of lending money (or some other asset) to a borrower. Interest is mainly charged as a specified percentage of the loan's value, per

Question: Describe the meaning of ABC inventory control and on what key premise is this system based? The finance department of Electric Corporation gathered the following i

Functions of money in any modern economy: A medium of exchange: Money facilitates the exchange of goods and services because, people exchange the goods and services they produ