A Macroeconomics Reader

By Brian Snowdon; Howard R. Vane | Go to book overview

APPENDIX A: AGGREGATE SUPPLY

The underlying inspiration for rational expectations macro models is derived from the notion of general equilibrium. With price flexibility, for given endowments and skills, a condition of general equilibrium requires equilibrium in the labor markets. In such a world all unemployment is voluntary, everybody who wants a job has one. Every individual has labor hours and assets allocated according to some personal optimum. The remaining unemployment can be termed the ‘natural’ rate of unemployment and the level of output termed the ‘natural’ level of output.

Abstracting from inter-industry shifts in production, the only way output can change is through a change in employment. To increase or decrease the level of output government policy must alter the equilibrium in the labor markets. But if the natural rate of unemployment represents an optimal position for private actors, how can government policy affect it?

The models rational expectations theorists usually work with suggest that this is possible only if the government is able to fool people. If people confuse nominal wage changes for real ones, they might reallocate their portfolios and their hours of work, and thus increase output. While allowing for this possibility the models suggest that such a change would not be desirable for the worker (representing a suboptimal decision) and would be avoided if they had rational expectations. They suggest that the labor supply decision is made in real terms so that labor market equilibrium is independent of prices which, in turn, is taken to imply that output is independent of prices. This result is presented in a vertical aggregate supply curve.

Alternative macro-economic theories suggest that the optimal allocation decisions of private actors will be affected by changes in prices, but not just because people are fooled. If this were true, increases in aggregate demand could increase output and employment even with rational expectations. One argument for the proposition suggests that people don’t hold money in their asset portfolios simply for transaction purposes. If prices go up, the desirability of holding such money goes down, changing people’s private allocation decisions, and perhaps the rate of capital formation or number of hours worked. Thus it might be said that the rational expectations models assume that the only motive for holding money is the transactions motive.


APPENDIX B: ALGEBRA OF THE MODEL

Supply:

(1)

Demand: yt=−bpt+cxt

(2)

Expectations:

(3)

-307-

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