3. The rational expectations model

Suppose the U.S. economy is in equilibrium at a potential output of $6 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 80.

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 the short-runeffect of this policy by shifting the appropriate curve or curves.

Note: Select and drag one, both, or all of the curves to the desired position. Curves will snap into position, so if you try to move a curve and it snaps back to its original position, just drag it a little farther.

120 LRAS O 110 SRAS AD 100 O SRAS PRICE LEVEL 80 O 70 LRAS 60 AD 50 40 2 3 4 5 7 8 9 10 QUANTITY OF OUTPUT (Trillions of dollars)Anticipated Expansionary Policy Unanticipated Expansionary Policy Short-Run Change in Output Long-Run Change in Price Level Long-Run Change in Output