Suppose an econometrician discovers that during the past decade, lower unemployment rates have always been accompanied by higher inflation rates. When asked how to reduce unemployment, the econometrician recommends the policy of increasing the money supply to trigger more inflation. Explain why this policy may fail to work in a world where people have rational expectations.

Question

What will be an ideal response?

Answer 1

If people have rational expectations, the policy of increasing the money supply may alter their behavior and invalidate the relationship between unemployment and inflation discovered by the econometrician. For instance, when people learn that the government is increasing the money supply, they may anticipate the rise in inflation and build it into their labor contracts. Thus, the policy may create more inflation without lowering unemployment. The policy change, by leading people to change their expectations and their behavior, can eliminate the source of the tradeoff between unemployment and inflation.