infaltion and rational ecpectation
... 2 Can policy time lags cause monetary policy to be procyclical? Explain clearly. Yes, time lags can cause procyclical behavior. Unlike fiscal policies, monetary policies are usually indirect. Changes in money supply do not lead to immediate changes on output or prices. As such, attempts to shift the AD curve outwards, takes a fairly long time to affect the economy. And there are several lags, such as the data, recognition , legislative , implementation and effective lag, to prevent the immediate adjustment on output and prices. Usually, such lags prevent policy-makers to retrieve the exact information on the economy rapidly. Thus the information does not accurately affect the current economic situation. Invisible mechanism allows the market to shift on its own. By the time the policy takes effect, conditions of the market are likely to change and do not address the problem. Hence, the policy may aggravate the situation. This brings about procyclical behavior. This is also why the activists argue that self-correcting mechanism is sluggish and unemployment will persist for a long time. As such, one should engage in active polices to shift the AD function. Lags bring about inappropriate policies to counter the economic situation. Because of these long lags, the policy-makers cannot base its decision on current levels of output and inflation alone. Instead, they must try to forecast what the economy will be doing six months or even two years in the future. Thus making the policy based on forecast, this is often inaccurate and may worsen the situation. This phenomenon will be similar to one of procyclical movement where the economy is unable to get itself out of its problem. 3 According to the New Classical economists, the best anti-inflation policy is to go “cold-turkey”. However, the New Keynesians advocate a gradual reduction of inflation. Explain the reasons for their different approaches. The major differences for the different approaches taken by 2 groups are mainly due to the different assumption. Although both assume that expectation is rational (i.e. meaning that the expectation changes when the behavior of forecasted variable changes), the New Classical model assumes that wages and prices are completely flexible. Hence, changes in money supply will cause the AD to shift and price to fluctuate. Thus, the new classical view of the best anti-inflationary policy is to have a drastic reduction in money supply, meaning to go ‘cold turkey’. Decreases the growth of money supply sharply, will stop the rise in the AD curve, maintaining it at the original position. If the policy is anticipated, the AS curve will shift to the left, and price level will decrease by a little. However, aggregate output will decrease too. If the policy is unanticipated, AS will remain and inflation will be eliminated with no loss in output. But for the policy to take effect, it must be announced and credible. This is important because it affects the public’s trust in the policy makers. Yet this results in anticipated expectation for the public. Thus, the new classical economists counter having surprises policies to create an unanticipated effect. However, this leads to uncertainty causing unnecessary fluctuations in output, which is undesirable. They argue that even if the public have rational expectations, it is possible that they make mistakes and thus AS will remain and position. Therefore, the ‘cold turkey treatment’ will help counter inflation. On the other hand, the new Keynesian who believes in wage-price rigidity (such as work collateral agreements and long term business agreements to have fix prices) believes that money supply is not the factor that allows the AD to shift. Thus, drastic drop in money supply will not actually stop AD from moving outwards and AD still moves to outwards, increasing prices. In fact, a drastic drop in money supply will not cause prices to decrease and in fact will decrease output and unemployment; hence the cold-turkey policy may not be desirable. They believe that gradual reduction in money...