One article of faith of the free market argument is that the economy is basically self-correcting—that it can cure inflation and recession if left alone. The mechanism that does this, of course, is individual rationality. Consider Figure 7–1. Let us assume that the economy is at a full employment equilibrium with price level P E and real GNP Q E , which we will assume is the natural rate of output. There is a sudden demand shock to the economy and the demand curve shifts to the right. If the supply curve remains unchanged, the new equilibrium will be at Q′ E P′ E . However, this new equilibrium involves a higher price level than Q E —inflationhas set in. As rational workers learn this, they will realize that their real wages have fallen and demand higher wages. This will increase the cost of production and shift the supply curve back to S′. The economy will return to the natural rate of output, but at a higher price level.
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- 6.John F. Muth, “Rational Expectations and the Theory of Price Movement,” Econometrica, July 1961, pp. 315.Google Scholar
- 7.Robert E. Lucas, Jr., “Some International Evidence on Output-Inflation Tradeoffs,” American Economic Review June 1973, pp. 326–334. We use this particular model because it is widely used in the rational-expectations literature. In models of this class, expectations of monetary policy are often assumed to be rational.Google Scholar