What are rational expectations, and how might rational expectations make monetary policy ineffective?
What will be an ideal response?
Rational expectations is the assumption that people make forecasts of future values of a variable using all available information, so expectations equal optimal forecasts, using all available information. With rational expectations, if the central bank is credible and policy changes are announced, the moment a policy is announced, such as an increase in the target rate of inflation to attempt to temporarily boost the economy, expectations of inflation increase immediately, so real GDP never exceeds potential GDP and the economy never experiences the temporary expansion. Therefore, there is no trade-off between unemployment and inflation when expectations are rational and policy changes are anticipated. This will make monetary policy ineffective.
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a. True b. False
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