SummaryInflation and unemployment can be very harmful to the economy. However, knowing how a problem originates is always helpful when trying to fix it. This is the reason why economists have created an incredible amount of economic models that try to explain how inflation and unemployment behave. In this LP we take a look at a few economic models that explain, at least to some extent or in some given context, inflation and unemployment.
New Classical Macroeconomics takes expectations one step further than monetarists did when using adaptive expectations. Rather than supposing that agents will learn to adjust their behaviour based on past experiences, they apply rational expectations, and directly assume that:
- All agents have sufficient working knowledge of the economy and its basic structural relationships to anticipate cause and effect;
- All agents assume that markets naturally reach an equilibrium;
- Information is perfect: market force drivers are ‘common knowledge’.
This all signals a return to the cornerstones of neoclassical economics, and although in practical terms it may be a slight stretch, it means taking the expectations-augmented Phillips curve one step further:
As New Classical Macroeconomics views it, agents are able to anticipate future events without needing to have experienced them previously. This time around, agents will anticipate expansionist monetary policies, and therefore skip point B. Agents have sufficient working knowledge of the economy and monetary policy is transparent enough for agents to directly associate a fall in interest rates with a rise in inflation. Therefore, they waste no time in asking for salary raises (the change on inflation expectations shift the curve directly to point C), and inflation rises before a drop in unemployment is ever reached. Expansionist monetary policy is not even effective in the short term. In the very short term, a small effect might exist, but only as a result of the time needed for expectations to lead to action.
The only way for monetary policy to work under these scenarios is for it to be enough of a surprise and of enough magnitude to pose an economic shock. If agents are not expecting dramatic policy, they have no time to put themselves in order. In this way, economic policy must go beyond expectations, otherwise even an inkling that the government is likely to act will lead to agents immediately counteracting policy, probably before policy is even enacted.