pcecon.com Class Notes
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When the Fed puts into place an expansionary monetary policy, what happens (compared to the original situation)?
In the short run,
real interest rates fall,
aggregate demand increases,
the price level will rise a bit,
real GDP will go up compared to the original situation,
real wages in the short run will appear to be lower (because of higher price level).
Higher real GDP means demand for labor is higher than before;
the low real wages along with the increases demand for labor, put upward pressure on wages,
the higher price level will also start pushing real interest rates up.

In the long run,
higher wages push SR aggregate supply to the left, raising the price level and lowering real GDP to the long run full employment level.
Real GDP reuturns to the original level, price level is higher, real interest rates and real wages are back where they started. All nominal prices are higher.

Remember from our discussions of the short run that the short run is based on resource sellers and others incorrectly anticipating the inflation rate and price level. If inflation is anticipated, then there is no short run increase in real GDP, and no other real changes. The economy gets to the long run right away. If all changes in the price level are acted upon immediately, then we say the policy is anticipated (fully).

To have even short run effects, monetary policy (and its effects on inflation) has to be unanticipated.

Timing is crucial if the Fed is to have desired real effects, even if the policy is unaticipated.

People who worry that the timing of policy may interfere with the self-correcting mechanisim and keep the economy from reaching long run equilibrium (without overshooting it) say we should not try to fine tune the economy. The policy they favor is called non-activist (in general), or, in the case of monetary theory, monetarist.

Activists favor trying to correct problems with the economy by using policy (either fiscal policy, or monetary policy).

Since expectations about inflation determine the effectiveness of policy, everything depends on the kind of expectations.
If people expect inflation to be just like the past, we say they have adaptive expectations. With these kind of expectations, monetary policy can be effective.

If people make decisions with some understanding and anticipation about how policy will affect inflation, then we say they have rational expectations. With these kinds of expectations, all policy effects are anticipated and nothing real changes with monetary policy. Only the price level will change.
Rational expectations could occur if labor contracts and interest rates are set up in such a way that they automatically change with inflation. In labor contracts, this could take the form of automatic cost of living adjustments. Adjustable rate loans, with interest rates changing automatically with inflation, are another method for people to anticipate inflation, even if they are not exactly sophisticated about the effects of policy.