Critically analyse the monetary policy ineffectiveness proposition under rational expectations. 24/25

Q: What is the monetary policy ineffectiveness proposition (MPI)?

A: Systematic, anticipated monetary policy has no effect on real output or employment.

Q: Who is the MPI proposition associated with?

A: Lucas, Sargent, and Wallace (New Classical economists).

Q: What expectations assumption underpins MPI?

A: Rational expectations.

Q: What does "systematic policy" mean in MPI?

A: Policy that follows a predictable rule.

Q: What does MPI say about surprise monetary policy?

A: Only unanticipated policy can affect output temporarily.

Q: How do agents respond to anticipated monetary contraction under RE?

A: They adjust prices and wages immediately.

Q: Why does anticipated policy not change real wages?

A: Nominal wages adjust in line with expected inflation.

Q: Why does aggregate supply not change under anticipated policy?

A: Firms face no misperceptions about relative prices.

Q: What happens to inflation after a credible contractionary policy?

A: Inflation falls immediately.

Q: What happens to output after anticipated contractionary policy?

A: No change.

Q: What information do agents use under rational expectations?

A: All available information, including policy rules.

Q: Are forecast errors systematic under RE?

A: No — they are random.

Q: Why does RE eliminate exploitable Phillips Curve trade-offs?

A: Agents anticipate inflation correctly.

Q: Shape of the Phillips Curve under MPI?

A: Vertical, even in the short run.

Q: Why is there no short-run Phillips Curve trade-off?

A: Inflation expectations adjust instantly.

Q: What happens to unemployment under anticipated policy?

A: Remains at the natural rate.

Q: How does MPI relate to policy rules?

A: Rules dominate discretion because discretion is ineffective.

Q: What is the policy implication of MPI?

A: Central banks should commit to rules, not activism.

Q: Does MPI argue monetary policy is useless?

A: No — it stabilises inflation but not output.

Q: Key price assumption in MPI models?

A: Perfectly flexible prices and wages.

Q: Labour market assumption in MPI?

A: Continuous market clearing.

Q: Information assumption in MPI?

A: Full and costless information.

Q: Credibility assumption in MPI?

A: Policy is perfectly credible.

Q: Do New Keynesians accept rational expectations?

A: Yes.

Q: Why does monetary policy affect output in NK models?

A: Nominal rigidities prevent instant price adjustment.

Q: What happens to output after contractionary policy in NK models?

A: Output falls in the short run.

Q: What happens to inflation in NK models?

A: Inflation declines gradually.

Q: What does this imply about MPI?

A: MPI fails once nominal rigidities are introduced.

Q: What empirical pattern contradicts MPI?

A: Disinflations are associated with recessions.

Q: Which historical episode challenges MPI?

A: Volcker disinflation (early 1980s).

Q: What does observed output volatility suggest?

A: Monetary policy has real short-run effects.

Q: When does MPI hold approximately?

A: When policy is highly credible and anticipated.

Q: What reduces the output cost of disinflation?

A: Strong credibility and forward guidance.

Q: How does credibility relate to RE?

A: Better expectations anchoring → closer to MPI outcome.

Q: Why is MPI rejected under adaptive expectations?

A: Agents systematically misforecast inflation.

Q: Output response under AE vs RE?

A: AE: strong output effects; RE: none if anticipated.

Q: Main theoretical strength of MPI?

A: Internal consistency and microfoundations.

Q: Main weakness of MPI?

A: Unrealistic assumptions about flexibility and information.

Q: Is monetary policy ineffective in practice?

A: No — only under restrictive New Classical conditions.

Q: Examiner-friendly conclusion on MPI?

A: The proposition is theoretically elegant but empirically weak