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648 PART VI
Monetary Theory
in interest rates and by rapid financial innovation that made the correct
measurement of money far more difficult (see Chapter 3). In their view, this
period was an aberration, and the close correspondence of money and infla-
tion is sure to reassert itself. However, this has not yet occurred.
What is the underlying cause of the increased rate of money growth
that we see occurring from 1960 to 1980? We have identified two possible
sources of inflationary monetary policy: government adherence to a high
employment target and budget deficits. Let’s see if budget deficits can explain
the move to an inflationary monetary policy by plotting the ratio of govern-
ment debt to GDP in Figure 9. This ratio provides a reasonable measure of
whether government budget deficits put upward pressure on interest rates.
Only if this ratio is rising might there be a tendency for budget deficits to
raise interest rates because the public is then being asked to hold more gov-
ernment bonds relative to their capacity to buy them. Surprisingly, over the
course of the 20-year period from 1960 to 1980, this ratio was falling, not
rising. Thus U.S. budget deficits in this period did not raise interest rates and
so could not have encouraged the Fed to expand the money supply by buy-
ing bonds. Therefore, Figure 9 tells us that we can rule out budget deficits as
a source of the rise in inflation in this period.
Because politicians were frequently bemoaning the budget deficits in
this period, why did deficits not lead to an increase in the debt–GDP ratio?
The reason is that in this period, U.S. budget deficits were sufficiently small
that the increase in the stock of government debt was still slower than the
growth in nominal GDP, and the ratio of debt to GDP declined. You can see
that interpreting budget deficit numbers is a tricky business.
6
We have ruled out budget deficits as the instigator; what else could be
the underlying cause of the higher rate of money growth and more rapid
inflation in the 1960s and 1970s? Figure 10, which compares the actual

unemployment rate to the natural rate of unemployment, shows that the
economy was experiencing unemployment below the natural rate in all but
one year between 1965 and 1973. This suggests that in 1965–1973, the
American economy was experiencing the demand-pull inflation described in
Figure 6.
Policymakers apparently pursued policies that continually shifted the
aggregate demand curve to the right in trying to achieve an output target that
was too high, thus causing the continual rise in the price level outlined in
Figure 6. This occurred because policymakers, economists, and politicians
had become committed in the mid-1960s to a target unemployment rate of
4%, the level of unemployment they thought was consistent with price sta-
bility. In hindsight, most economists today agree that the natural rate of
unemployment was substantially higher in this period, on the order of 5 to
6%, as shown in Figure 10. The result of the inappropriate 4% unemployment
6
Another way of understanding the decline in the debt–GDP ratio is to recognize that a rise in the price level
reduces the value of the outstanding government debt in real terms—that is, in terms of the goods and services it
can buy. So even though budget deficits did lead to a somewhat higher nominal amount of debt in this period, the
continually rising price level (inflation) produced a lower real value of the government debt. The decline in the real
amount of debt at the same time that real GDP was rising in this period then resulted in the decline in the
debt–GDP ratio. For a fascinating discussion of how tricky it is to interpret deficit numbers, see Robert Eisner and
Paul J. Pieper, “A New View of the Federal Debt and Budget Deficits,” American Economic Review 74 (1984): 11–29.

/usbudget/
The Economic Report of the
President reports debt levels
and gross domestic product,
along with many other
economic statistics.
CHAPTER 27

Money and Inflation
649
FIGURE 9 Government Debt-to-GDP Ratio, 1960–2002
Source: Economic Report of the President.
1960 1965 1970 1975 1980 1985 1990 1995 20052000
0
20
30
40
50
60
Debt (% of GDP)
FIGURE 10 Unemployment and the Natural Rate of Unemployment, 1960–2002
Sources: Economic Report of the President and Congressional Budget Office.
3
4
5
6
7
8
9
10
1960 1965 1970 1975 1980 1985 1990 1995 2000
Unemployment Rate
Natural Rate of
Unemployment
Unemployment
Rate (%)
0
Activist/Nonactivist Policy Debate

All economists have similar policy goals—they want to promote high employment
and price stability—and yet they often have very different views on how policy should
be conducted. Activists regard the self-correcting mechanism through wage and price
adjustment (see Chapter 25) as very slow and hence see the need for the government
to pursue active, accommodating, discretionary policy to eliminate high unemploy-
ment whenever it develops. Nonactivists, by contrast, believe that the performance of
the economy would be improved if the government avoided active policy to eliminate
unemployment. We will explore the activist/nonactivist policy debate by first looking
at what the policy responses might be when the economy experiences high unem-
ployment.
Suppose that policymakers confront an economy that has moved to point 1Ј in Figure
11. At this point, aggregate output Y
1Ј
is lower than the natural rate level, and the
economy is suffering from high unemployment. Policymakers have two viable
choices: If they are nonactivists and do nothing, the aggregate supply curve will even-
tually shift rightward over time, driving the economy from point 1Ј to point 1, where
full employment is restored. The accommodating, activist alternative is to try to elim-
inate the high unemployment by attempting to shift the aggregate demand curve
rightward to AD
2
by pursuing expansionary policy (an increase in the money supply,
increase in government spending, or lowering of taxes). If policymakers could shift
the aggregate demand curve to AD
2
instantaneously, the economy would immediately
move to point 2, where there is full employment. However, several types of lags pre-
vent this immediate movement from occurring.
1. The data lag is the time it takes for policymakers to obtain the data that tell
them what is happening in the economy. Accurate data on GDP, for example, are not

available until several months after a given quarter is over.
2. The recognition lag is the time it takes for policymakers to be sure of what the
data are signaling about the future course of the economy. For example, to minimize
errors, the National Bureau of Economic Research (the organization that officially
Responses to
High
Unemployment
650 PART VI
Monetary Theory
target was the beginning of the most sustained inflationary episode in
American history.
After 1975, the unemployment rate was regularly above the natural rate
of unemployment, yet inflation continued. It appears that we have the phe-
nomenon of a cost-push inflation described in Figure 5 (the impetus for
which was the earlier demand-pull inflation). The persistence of inflation can
be explained by the public’s knowledge that government policy continued to
be concerned with achieving high employment. With a higher rate of
expected inflation arising initially from the demand-pull inflation, the aggre-
gate supply curve in Figure 5 continued to shift leftward, causing a rise in
unemployment that policymakers would try to eliminate by shifting the
aggregate demand curve to the right. The result was a continuation of the
inflation that had started in the 1960s.
dates business cycles) will not declare the economy to be in recession until at least six
months after it has determined that one has begun.
3. The legislative lag represents the time it takes to pass legislation to implement
a particular policy. The legislative lag does not exist for most monetary policy actions
such as open market operations. It can, however, be quite important for the imple-
mentation of fiscal policy, when it can sometimes take six months to a year to get leg-
islation passed to change taxes or government spending.
4. The implementation lag is the time it takes for policymakers to change policy

instruments once they have decided on the new policy. Again, this lag is unimportant
for the conduct of open market operations because the Fed’s trading desk can pur-
chase or sell bonds almost immediately upon being told to do so by the Federal Open
Market Committee. Actually implementing fiscal policy may take time, however; for
example, getting government agencies to change their spending habits takes time, as
does changing tax tables.
5. The effectiveness lag is the time it takes for the policy actually to have an impact
on the economy. An important element of the monetarist viewpoint is that the effec-
tiveness lag for changes in the money supply is long and variable (from several
months to several years). Keynesians usually view fiscal policy as having a shorter
effectiveness lag than monetary policy (fiscal policy takes approximately a year until
its full effect is felt), but there is substantial uncertainty about how long this lag is.
Now that we understand the considerations that affect decisions by policymakers on
whether to pursue an activist or nonactivist policy, we can examine when each of
these policies would be preferable.
Activist and
Nonactivist
Positions
CHAPTER 27
Money and Inflation
651
FIGURE 11 The Choice
Between Activist and Nonactivist
Policy
When the economy has moved to
point 1Ј, the policymaker has two
choices of policy: the nonactivist
policy of doing nothing and letting
the economy return to point 1 or
the activist policy of shifting the

aggregate demand curve to AD
2
to
move the economy to point 2.
Aggregate
Price Level, P
P
1Ј
P
1
Y
1Ј
Y
n
Aggregate Output, Y
P
2
P
2Ј
Y
2Ј
2Ј
AD
1
AD
2
AS
1
1
AS

2
1Ј
2
Case for an Activist Policy. Activists, such as the Keynesians, view the wage and price
adjustment process as extremely slow. They consider a nonactivist policy costly,
because the slow movement of the economy back to full employment results in a large
loss of output. However, even though the five lags described result in delay of a year
or two before the aggregate demand curve shifts to AD
2
, the aggregate supply curve
likewise moves very little during this time. The appropriate path for policymakers to
pursue is thus an activist policy of moving the economy to point 2 in Figure 11.
Case for a Nonactivist Policy. Nonactivists, such as the monetarists, view the wage and
price adjustment process as more rapid than activists do and consider nonactivist pol-
icy less costly because output is soon back at the natural rate level. They suggest that
an activist, accommodating policy of shifting the aggregate demand curve to AD
2
is
costly, because it produces more volatility in both the price level and output. The rea-
son for this volatility is that the time it takes to shift the aggregate demand curve to
AD
2
is substantial, whereas the wage and price adjustment process is more rapid.
Hence before the aggregate demand curve shifts to the right, the aggregate supply
curve will have shifted rightward to AS
2
, and the economy will have moved from
point 1Ј to point 1, where it has returned to the natural rate level of output Y
n
. After

adjustment to the AS
2
curve is complete, the shift of the aggregate demand curve to
AD
2
finally takes effect, leading the economy to point 2Ј at the intersection of AD
2
and
AS
2
. Aggregate output at Y
2Ј
is now greater than the natural rate level (Y
2Ј
> Y
n
), so
the aggregate supply curve will now shift leftward back to AS
1
, moving the economy
to point 2, where output is again at the natural rate level.
Although the activist policy eventually moves the economy to point 2 as policy-
makers intended, it leads to a sequence of equilibrium points—1Ј, 1, 2Ј, and 2—at
which both output and the price level have been highly variable: Output overshoots its
target level of Y
n
, and the price level falls from P
1Ј
to P
1

and then rises to P
2Ј
and even-
tually to P
2
. Because this variability is undesirable, policymakers would be better off
pursuing the nonactivist policy, which moved the economy to point 1 and left it there.
Our analysis of inflation in the 1970s demonstrated that expectations about policy
can be an important element in the inflation process. Allowing for expectations about
policy to affect how wages are set (the wage-setting process) provides an additional
reason for pursuing a nonactivist policy.
Do Expectations Favor a Nonactivist Approach? Does the possibility that expectations
about policy matter to the wage-setting process strengthen the case for a nonactivist
policy? The case for an activist policy states that with slow wage and price adjustment,
the activist policy returns the economy to full employment at point 2 far more quickly
than it takes to get to full employment at point 1 under nonactivist policy. However,
the activist argument does not allow for the possibility (1) that expectations about
policy matter to the wage-setting process and (2) that the economy might initially
have moved from point 1 to point 1Ј because an attempt by workers to raise their
wages or a negative supply shock shifted the aggregate supply curve from AS
2
to AS
1
.
We must therefore ask the following question about activist policy: Will the aggregate
supply curve continue to shift to the left after the economy has reached point 2, lead-
ing to cost-push inflation?
The answer to this question is yes if expectations about policy matter. Our dis-
cussion of cost-push inflation in Figure 5 suggested that if workers know that policy
will be accommodating in the future, they will continue to push their wages up, and

Expectations and
the Activist/
Nonactivist
Debate
652 PART VI
Monetary Theory
the aggregate supply curve will keep on shifting leftward. As a result, policymakers
are forced to accommodate the cost push by continuing to shift the aggregate demand
curve to the right to eliminate the unemployment that develops. The accommodating,
activist policy with its high employment target has the hidden cost or disadvantage
that it may well lead to inflation.
7
The main advantage of a nonaccommodating, nonactivist policy, in which poli-
cymakers do not try to shift the aggregate demand curve in response to the cost push,
is that it will prevent inflation. As depicted in Figure 4, the result of an upward push
on wages in the face of a nonaccommodating, nonactivist policy will be a period of
unemployment above the natural rate level, which will eventually shift the aggregate
supply curve and the price level back to their initial positions. The main criticism of
this nonactivist policy is that the economy will suffer protracted periods of unem-
ployment when the aggregate supply curve shifts leftward. Workers, however, would
probably not push for higher wages to begin with if they knew that policy would be
nonaccommodating, because their wage gains will lead to a protracted period of
unemployment. A nonaccommodating, nonactivist policy may have not only the
advantage of preventing inflation but also the hidden benefit of discouraging leftward
shifts in the aggregate supply curve that lead to excessive unemployment.
In conclusion, if workers’ opinions about whether policy is accommodating or
nonaccommodating matter to the wage-setting process, the case for a nonactivist
policy is much stronger.
Do Expectations About Policy Matter to the Wage-Setting Process? The answer to this
question is crucial to deciding whether activist or nonactivist policy is preferred and

so has become a major topic of current research for economists, but the evidence is
not yet conclusive. We can ask, however, whether expectations about policy do affect
people’s behavior in other contexts. This information will help us know if expecta-
tions regarding whether policy is accommodating are important to the wage-setting
process.
As any good negotiator knows, convincing your opponent that you will be non-
accommodating is crucial to getting a good deal. If you are bargaining with a car
dealer over price, for example, you must convince him that you can just as easily walk
away from the deal and buy a car from a dealer on the other side of town. This prin-
ciple also applies to conducting foreign policy—it is to your advantage to convince
your opponent that you will go to war (be nonaccommodating) if your demands are
not met. Similarly, if your opponent thinks that you will be accommodating, he will
almost certainly take advantage of you (for an example, see Box 1). Finally, anyone
who has dealt with a two-year-old child knows that the more you give in (pursue an
accommodating policy), the more demanding the child becomes. People’s expecta-
tions about policy do affect their behavior. Consequently, it is quite plausible that
expectations about policy also affect the wage-setting process.
8
CHAPTER 27
Money and Inflation
653
7
The issue that is being described here is the time-consistency problem described in Chapter 21.
8
A recent development in monetary theory, new classical macroeconomics, strongly suggests that expectations
about policy are crucial to the wage-setting process and the movements of the aggregate supply curve. We will
explore why new classical macroeconomics comes to this conclusion in Chapter 28, when we discuss the impli-
cations of the rational expectations hypothesis, which states that expectations are formed using all available infor-
mation, including expectations about policy.
The following conclusions can be generated from our analysis: Activists believe in the

use of discretionary policy to eliminate excessive unemployment whenever it devel-
ops, because they view the wage and price adjustment process as sluggish and unre-
sponsive to expectations about policy. Nonactivists, by contrast, believe that a
discretionary policy that reacts to excessive unemployment is counter-productive,
because wage and price adjustment is rapid and because expectations about policy
can matter to the wage-setting process. Nonactivists thus advocate the use of a policy
rule to keep the aggregate demand curve from fluctuating away from the trend rate of
growth of the natural rate level of output. Monetarists, who adhere to the nonactivist
position and who also see money as the sole source of fluctuations in the aggregate
demand curve, in the past advocated a policy rule whereby the Federal Reserve keeps
the money supply growing at a constant rate. This monetarist rule is referred to as a
constant-money-growth-rate rule. Because of the misbehavior of velocity of M1 and
M2, monetarists such as Bennett McCallum and Alan Meltzer of Carnegie-Mellon
University have advocated a rule for the growth of the monetary base that is adjusted
for past velocity changes.
As our analysis indicates, an important element for the success of a nonaccom-
modating policy rule is that it be credible: The public must believe that policymakers
will be tough and not accede to a cost push by shifting the aggregate demand curve
to the right to eliminate unemployment. In other words, government policymakers
need credibility as inflation-fighters in the eyes of the public. Otherwise, workers will
be more likely to push for higher wages, which will shift the aggregate supply curve
leftward after the economy reaches full employment at a point such as point 2 in
Figure 11 and will lead to unemployment or inflation (or both). Alternatively, a cred-
ible, nonaccommodating policy rule has the benefit that it makes a cost push less
likely and thus helps prevent inflation and potential increases in unemployment. The
following application suggests that recent historical experience is consistent with the
importance of credibility to successful policymaking.
Rules Versus
Discretion:
Conclusions

654 PART VI
Monetary Theory
Box 1
Perils of Accommodating Policy
The Terrorism Dilemma. A major dilemma con-
fronting our foreign policy in recent years is whether to
cave in to the demands of terrorists when they are hold-
ing American hostages. Because our hearts go out to the
hostages and their families, we might be tempted to
pursue an accommodating policy of giving in to the ter-
rorists to bring the hostages safely back home.
However, pursuing this accommodating policy is likely
to encourage terrorists to take hostages in the future.
The terrorism dilemma illustrates the principle
that opponents are more likely to take advantage of
you in the future if you accommodate them now.
Recognition of this principle, which demonstrates the
perils of accommodating policy, explains why gov-
ernments in countries such as the United States and
Israel have been reluctant to give in to terrorist
demands even though it has sometimes resulted in
the death of hostages.
CHAPTER 27
Money and Inflation
655
Importance of Credibility to Volcker’s Victory over Inflation
Application
In the period from 1965 through the 1970s, policymakers had little credibil-
ity as inflation-fighters—a well-deserved reputation, as they pursued an
accommodating policy to achieve high employment. As we have seen, the

outcome was not a happy one. Inflation soared to double-digit levels, while
the unemployment rate remained high. To wring inflation out of the system,
the Federal Reserve under Chairman Paul Volcker put the economy through
two back-to-back recessions in 1980 and 1981–1982 (see Chapter 18). (The
data on inflation, money growth, and unemployment in this period are
shown in Figures 8 and 10.) Only after the 1981–1982 recession—the most
severe in the postwar period, with unemployment above the 10% level—did
Volcker establish credibility for the Fed’s anti-inflation policy. By the end of
1982, inflation was running at a rate of less than 5%.
One indication of Volcker’s credibility came in 1983 when the money
growth rate accelerated dramatically and yet inflation did not rise. Workers
and firms were convinced that if inflation reared its head, Volcker would pur-
sue a nonaccommodating policy of quashing it. They did not raise wages and
prices, which would have shifted the aggregate supply curve leftward and
would have led to both inflation and unemployment. The success of Volcker’s
anti-inflation policy continued throughout the rest of his term as chairman,
which ended in 1987; unemployment fell steadily, while the inflation rate
remained below 5%. Volcker’s triumph over inflation was achieved because
he obtained credibility the hard way—he earned it.
Summary
1. Milton Friedman’s famous proposition that “inflation is
always and everywhere a monetary phenomenon” is
supported by the following evidence: Every country
that has experienced a sustained, high inflation has also
experienced a high rate of money growth.
2. Aggregate demand and supply analysis shows that
Keynesian and monetarist views of the inflation process
are not very different. Both believe that high inflation
can occur only if there is a high rate of money growth.
As long as we recognize that by inflation we mean a

rapid and continuing increase in the price level, almost
all economists agree with Friedman’s proposition.
3. Although high inflation is “always and everywhere a
monetary phenomenon” in the sense that it cannot
occur without a high rate of money growth, there are
reasons why inflationary monetary policy comes about.
The two underlying reasons are the adherence of
policymakers to a high employment target and the
presence of persistent government budget deficits.
4. Activists believe in the use of discretionary policy to
eliminate excessive unemployment whenever it occurs
because they view wage and price adjustment as
sluggish and unresponsive to expectations about policy.
Nonactivists take the opposite view and believe that
discretionary policy is counterproductive. In addition,
they regard the credibility of a nonaccommodating
(nonactivist) anti-inflation policy as crucial to its
success.
656 PART VI
Monetary Theory
Key Terms
accommodating policy, p. 640
constant-money-growth-rate rule,
p. 654
cost-push inflation, p. 639
demand-pull inflation, p. 639
government budget constraint, p. 643
monetizing the debt, p. 644
printing money, p. 644
Ricardian equivalence, p. 645

Questions and Problems
Questions marked with an asterisk are answered at the end
of the book in an appendix, “Answers to Selected Questions
and Problems.”
1. “There are frequently years when the inflation rate is
high and yet money growth is quite low. Therefore,
the statement that inflation is a monetary phenome-
non cannot be correct.” Comment.
*2. Why do economists focus on historical episodes of
hyperinflation to decide whether inflation is a mone-
tary phenomenon?
3. “Since increases in government spending raise the
aggregate demand curve in Keynesian analysis, fiscal
policy by itself can be the source of inflation.” Is this
statement true, false, or uncertain? Explain your
answer.
*4. “A cost-push inflation occurs as a result of workers’
attempts to push up their wages. Therefore, inflation
does not have to be a monetary phenomenon.” Is this
statement true, false, or uncertain? Explain your
answer.
5. “Because government policymakers do not consider
inflation desirable, their policies cannot be the source
of inflation.” Is this statement true, false, or uncertain?
Explain your answer.
*6. “A budget deficit that is only temporary cannot be the
source of inflation.” Is this statement true, false, or
uncertain? Explain your answer.
7. How can the Fed’s desire to prevent high interest rates
lead to inflation?

*8. “If the data and recognition lags could be reduced,
activist policy would more likely be beneficial to the
economy.” Is this statement true, false, or uncertain?
Explain your answer.
9. “The more sluggish wage and price adjustment is, the
more variable output and the price level are when an
activist policy is pursued.” Is this statement true, false,
or uncertain? Explain your answer.
*10. “If the public believes that the monetary authorities
will pursue an accommodating policy, a cost-push
inflation is more likely to develop.” Is this statement
true, false, or uncertain? Explain your answer.
11. Why are activist policies to eliminate unemployment
more likely to lead to inflation than nonactivist policies?
*12. “The less important expectations about policy are to
movements of the aggregate supply curve, the stronger
the case is for activist policy to eliminate unemploy-
ment.” Is this statement true, false, or uncertain?
Explain your answer.
13. If the economy’s self-correcting mechanism works
slowly, should the government necessarily pursue an
activist policy to eliminate unemployment?
*14. “To prevent inflation, the Fed should follow Teddy
Roosevelt’s advice: ‘Speak softly and carry a big stick.’”
What would the Fed’s “big stick” be? What is the state-
ment trying to say?
15. In a speech early in the Iraq-Kuwait crisis in 1990,
President George Bush stated that although his heart
went out to the hostages held by Saddam Hussein, he
would not let this hostage-taking deter the United

States from insisting on the withdrawal of Iraq from
Kuwait. Do you think that Bush’s position made sense?
Explain why or why not.
QUIZ
CHAPTER 27
Money and Inflation
657
Web Exercises
1. Figure 8 reports the inflation rate from 1960 to 2002.
As this chapter states, inflation continues to be a
major a factor in economic policy. Go to
.gov/pub/special.requests/cpi/cpiai.txt
. Move data into
Excel using the method described at the end of
Chapter 1. Delete all but the first and last column
(date and annual CPI). Graph this data and compare it
to Figure 8.
a. Has inflation increased or decreased since the end
of 2002?
b. When was inflation at its highest?
c. When was inflation at its lowest?
d. Have we ever had a period of deflation? If so,
when?
e. Have we ever had a period of hyperinflation? If so,
when?
2. It can be an interesting exercise to compare the pur-
chasing power of the dollar over different periods in
history. Go to www
.bls.gov/cpi/ and scroll down to the
link to the “inflation calculator.” Use this calculator to

compute the following:
a. If a new home cost $125,000 in 2002, what would
it have cost in 1950?
b. The average household income in 2002 was about
$37,000. How much would this have been in
1945?
c. An average new car cost about $18,000 in 2002.
What would this have cost in 1945?
d. Using the results you found in Questions b and c,
does a car consume more or less of average house-
hold income in 2002 than in 1945?

The Lucas Critique of Policy Evaluation
econometric models
The way in which expectations are formed (the
relationship of expectations to past information) changes when the behavior of forecasted
variables changes.
Example: The Term
Structure
of Interest Rates
Econometric
Policy Evaluation
CHAPTER 28
Rational Expectations: Implications for Policy
659
Carnegie-Rochester Conference Series on Public Policy

/het/pr
ofiles/lucas.htm
The Lucas critique points out not only that con-

ventional econometric models cannot be used for policy evaluation, but also that the
public’s expectations about a policy will influence the response to that policy.
New Classical Macroeconomic Model
new classical macroeconomic model
real
660 PART VI
Monetary Theory
AS
P
AD AS
P
Y
n
. Y
n
AD
P
AS
Ј AD AS
Y
Ј
P
Ј
Effects of
Unanticipated and
Anticipated Policy
CHAPTER 28
Rational Expectations: Implications for Policy
661
FIGURE 1 Short-Run Response

to Unanticipated Expansionary Policy
in the New Classical Model
AD AS
ϭ P
AD
AS
Ј
Y
؅
P
؅
Aggregate
Price Level, P
P
2Ј
P
1
Y
2Ј
Y
n
AD
1
AD
2
1
2Ј
AS
1
(expected

price level = P
1
)
Aggregate Output, Y
P
AS
AD
Y
n
P
AS
P
necessarily
classical
unanticipated
Anticipated policy has no effect on the business cycle; only unanticipated
policy matters.
662 PART VI
Monetary Theory
FIGURE 2 Short-Run Response
to Anticipated Expansionary Policy in
the New Classical Model
AD
AS
P
Aggregate
Price Level, P
P
2
P

1
Y
n
AD
1
AD
2
1
2
Aggregate Output, Y
AS
1
(expected
price level = P
1
)
AS
2
(expected price level = P
2
)
Y
n
policy ineffectiveness proposition
decline
AD
AS Y
n
P
AD

AS
P
AD
Ј
Ј AS
AD
Ј
Y
Ј
P
Ј
P
Can an
Expansionary
Policy Lead to
a Decline in
Aggregate
Output?
CHAPTER 28
Rational Expectations: Implications for Policy
663
Box 1
Proof of the Policy Ineffectiveness Proposition
necessarily
AD
AS
AD
Y
n
AS

AS
P
AS
Journal of Political Economy
Study Guide
Implications for
Policymakers
664 PART VI
Monetary Theory
FIGURE 3 Short-Run Response
to an Expansionary Policy That Is Less
Expansionary Than Expected in the
New Classical Model
AD
AS
ϭ P
AD
؅
Ј
AD
؅
AS
Y
؅
Aggregate
Price Level, P
P
2Ј
P
1

Y
n
AD
1
AD
2
1
2
Aggregate Output, Y
AS
1
(expected
price level = P
1
)
AS
2
(expected price level = P
2
)
P
2
2Ј
AD
2
Ј
Y
2Ј
does
New Keynesian Model

new Keynesians
wage–price
stickiness
CHAPTER 28
Rational Expectations: Implications for Policy
665
www.federalreserve.gov/pubs
/feds/2001/200113
/200113pap.pdf
new Keynesian model
does
AD
AS
P
AD
Y
U
P
U
AD
AD
complete
AS
AS
A
AD
AS
A
Y
A

P
A
Unlike the new classical model, in the new
Keynesian model anticipated policy does have an effect on aggregate output.
Y
U
Y
A
like the new
classical model, the new Keynesian model distinguishes between the effects of antic-
ipated versus unanticipated policy, with unanticipated policy having a greater effect
Comparison of the Two New Models with the Traditional Model
Implications for
Policymakers
Effects of
Unanticipated and
Anticipated Policy
666 PART VI
Monetary Theory
traditional model.
not
CHAPTER 28
Rational Expectations: Implications for Policy
667
FIGURE 4 Short-Run Response
to Expansionary Policy in the New
Keynesian Model
AD
Y
U

P
U
AS
A
AS
Y
A
Y
U
P
A
P
U
Aggregate
Price Level, P
P
U
P
1
Y
U
Y
n
AD
1
AD
2
1
U
AS

1
Aggregate Output, Y
Aggregate
Price Level, P
P
A
P
1
Y
n
AD
1
AD
2
1
A
Aggregate Output, Y
AS
1
AS
2
(a) Response to an unanticipated expansionary policy
P
U
AS
A
Y
A
Y
U

(b) Response to an anticipated expansionary policy
Study Guide
AD
AS
AD
Short-Run Output
and Price
Responses
668 PART VI
Monetary Theory
Table 1 The Three Models
SUMMARY
Is Credibility
Response to Response to Response to Response to Important to
Unanticipated Anticipated Can Activist Unanticipated Anticipated Successful
Expansionary Expansionary Policy Be Anti-inflation Anti-inflation Anti-inflation
Model Policy Policy Beneficial? Policy Policy Policy?
Y
↑
P
↑
Y
↑
P
↑
Y
↓
␲
↓
Y

↓
␲
↓
Y
↑
P
↑
Y Y
↓
␲
↓
Y
P
↑
␲
↓
Y
↑
P
↑
Y
↑
Y
↓
␲
↓
Y
↓
P
↑

␲
↓
Note:
␲
CHAPTER 28
Rational Expectations: Implications for Policy
669
FIGURE 5
Comparison of the Short-Run
Response to Expansionary Policy in
the Three Models
AD
AD
Ј
Ј
Ј
Ј
Aggregate
Price Level, P
P
1Ј
P
1
1Ј
Y
1Ј
Y
n
Aggregate Output, Y
AD

1
AD
2
AS
1
1
(a) Traditional model
Aggregate
Price Level, P
P
1Ј
P
1
1Ј
Y
1Ј
Y
n
Aggregate Output, Y
AD
1
AD
2
AS
1
1
(b) New classical
macroeconomic model
AS
2

2
P
2
Aggregate
Price Level, P
P
1Ј
P
1
1Ј
Y
1Ј
Y
n
Aggregate Output, Y
AD
1
AD
2
AS
1
1
(c) New Keynesian model
AS
2Ј
2Ј
P
2
P
2Ј

Y
2Ј
unanticipated
AS
unan-
ticipated Ј AD
AS
Y
Ј
P
Ј
anticipated
AS
Ј
AS
P
Ј
AS
Ј
Ј Y
Ј
Y
Ј
P
Ј
P
Ј
stabilization policy
Stabilization
Policy

670 PART VI
Monetary Theory
does
AD
AD
AS
AS
AD
AS
AD
AS P
P
AD
AS
AD
Ј
Anti-inflation
Policies
CHAPTER 28
Rational Expectations: Implications for Policy
671
672 PART VI
Monetary Theory
FIGURE 6
Anti-inflation Policy in the Three
Models
AD AD
AS
AS
AD

Ј
Ј
Ј
Љ
Aggregate
Price Level, P
P
2Ј
P
1
Y
n
Y
2Ј
Aggregate Output, Y
AD
1
AD
2
AS
1
1
(a) Traditional model
(b) New classical
macroeconomic model
(c) New Keynesian model
AS
2
P
2

2Ј
2
Aggregate
Price Level, P
P
2Ј
P
1
Y
n
Y
2Ј
Aggregate Output, Y
AD
1
AD
2
AS
1
1
AS
2
P
2
2Ј
2
Aggregate
Price Level, P
P
2Ј

P
1
Y
n
Y
2Ј
Aggregate Output, Y
AD
1
AD
2
1
P
2
2Ј
2
P
2Љ
2Љ
AS
1
AS
2
AS
2Љ
Y
2ЈЈ