Critically analyse the differences in the predictions of adaptive and rational expectations models with respect to a contractionary monetary policy? 24/25

Q: How are expectations formed under adaptive expectations?

A: Agents form expectations based on past inflation/errors, adjusting slowly over time.

Q: Do agents use full information under AE?

A: No — expectations are backward-looking and not model-consistent.

Q: What happens to inflation immediately after a contractionary monetary policy under AE?

A: Inflation falls gradually, not immediately.

Q: What happens to output in the short run under AE after contractionary policy?

A: Output falls below potential due to unexpected real interest rate increases.

Q: Why does monetary policy affect real variables under AE?

A: Because agents do not anticipate policy correctly, causing misperceptions.

Q: What is the short-run Phillips Curve implication under AE?

A: There is a short-run trade-off between inflation and unemployment.

Q: Does contractionary policy cause unemployment under AE?

A: Yes, temporarily, as wages and prices adjust slowly.

Q: What happens in the long run under AE?

A: Output returns to natural level; inflation permanently lower.

Q: Key weakness of AE models?

A: Expectations are systematically biased and ignore available information.

Q: How are expectations formed under rational expectations?

A: Agents use all available information and understand the true economic model.

Q: Are forecast errors systematic under RE?

A: No — errors are random, not predictable.

Q: Can anticipated monetary policy affect real output under RE?

A: No — anticipated policy is neutral.

Q: What happens to inflation under contractionary policy in RE models?

A: Inflation adjusts immediately if the policy is credible.

Q: What happens to output if contractionary policy is fully anticipated?

A: No change in output — only nominal variables adjust.

Q: Why is money neutral in RE models?

A: Because agents adjust prices and wages instantly.

Q: What price flexibility assumption defines New Classical models?

A: Prices and wages are fully flexible.

Q: What happens after a contractionary monetary policy in New Classical models?

A: Immediate fall in inflation, no effect on output.

Q: Can surprise monetary policy affect output in New Classical models?

A: Yes, but only temporarily and only if unanticipated.

Q: What is the Phillips Curve implication in New Classical models?

A: Vertical Phillips Curve even in the short run (if policy is anticipated).

Q: Policy implication from New Classical theory?

A: Systematic monetary policy is ineffective.

Q: What key assumption differentiates New Keynesian from New Classical models?

A: Nominal rigidities (sticky prices/wages).

Q: Do agents still have rational expectations in NK models?

A: Yes — expectations are forward-looking and model-consistent.

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

A: Output falls in the short run due to price rigidity.

Q: Why does contractionary policy reduce output in NK models despite RE?

A: Firms cannot instantly adjust prices, raising real interest rates.

Q: What happens to inflation in NK models?

A: Inflation falls gradually, not instantly.

Q: Is monetary policy effective under NK models?

A: Yes, in the short run.

Q: Shape of Phillips Curve in NK models?

A: Forward-looking, downward sloping in the short run.

Q: Key difference between AE and RE in policy prediction?

A: AE predicts systematic real effects; RE predicts neutrality if policy is anticipated.

Q: Speed of inflation adjustment: AE vs RE?

A: AE: slow; RE: immediate (if prices flexible).

Q: Output effects of contractionary policy: AE vs RE?

A: AE: output falls; RE: no effect if anticipated.

Q: Information use: AE vs RE?

A: AE uses past data; RE uses all available information.

Q: Why might AE models overstate policy effectiveness?

A: They assume agents repeatedly make the same forecasting errors.

Q: Why might RE models understate real-world policy effects?

A: They assume unrealistically fast price and wage adjustment.

Q: Which framework best matches observed disinflations?

A: New Keynesian — gradual inflation decline with output costs.

Q: What historical episode supports NK over New Classical models?

A: Volcker disinflation — sharp output loss with falling inflation.

Q: What role does credibility play in RE models?

A: Higher credibility reduces output costs of disinflation.