2) 4. The rational expectations model

Suppose the U.S. economy is in equilibrium at a potential output of $10 trillion so that unemployment is at the natural rate. At the beginning of the year, the Federal Reserve announces that its monetary policy will aim to maintain output at potential output and sustain the current price level throughout the year. Firms and workers negotiate annual wage and resource price agreements based on the belief that the Fed is committed to price stability.

The following graph shows the aggregate demand curve (AD), the long-run aggregate supply curve (LRAS), and the short-run aggregate supply curve (SRAS) at an expected price level of 120.

Now suppose that several months later, the Fed abandons its stated goal of price stability and shifts toward an expansionary monetary policy.

On the following graph, show theshort-runeffect of this policy by shifting the appropriate curve or curves.

110 LRAS SRAS 106 SRAS- 102 PRICE LEVEL SD K 98 AD AD 2 94 48 56 40 44 52 QUANTITY OF OUTPUT (Trillions of dollars)On the following graph, show the short-run effect of this policy by shifting the appropriate curve or cur 160 LRAS O 150 SRAS AD 140 130 SRAS 120 PRICE LEVEL 110 LRAS 100 AD 90 6 7 8 9 10 11 12 13 14 QUANTITY OF OUTPUT (Trillions of dollars) In the short run, the expansionary monetary policy will result in a price level of