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14.   Explain the theory of Rational Expectations and the long run Phillips curve.
ANS:
According to Milton Friedman’s theory of adaptive expectations, nominal wages lag changes in the price level or the inflation rate. The adjustment lag in nominal wages to the price level causes business profits to go up. When profits go up, business units expand their scale output and thus the level of unemployment in the economy falls below the natural rate. The advocates of rational expectation theory believe that there is no adjustment lag involved between nominal wages and changing price level. They argue that there is a quick adjustment between nominal wages and expected changes in the price level and hence there is no trade-off between inflation and unemployment. The rate of inflation resulting from increase in aggregate demand is well anticipated by workers and firms and gets factored in wage agreements. Such adjustments made in quick succession sometimes and sometimes in advance lead to further price increases. Thus, there is a rise in the price level without any rise in the real output or fall in unemployment below the natural rate. According to the Rational Expectations theorists, given the availability of resources and technology, the aggregate supply curve is vertically sloping at the potential GDP level or at the natural unemployment rate level. The long run Phillips curve the refore corresponds to the long run aggregate supply curve at the natural rate of unemployment. The long run Phillips curve is therefore a vertical straight line or vertically sloping at the natural rate of unemployment. The derivation of the long run aggregate supply curve is shown in Fig. 2A.5 and the long run Phillips curve is depicted in Fig. 2A.6.

According to the Rational Expectations theorists, the workers and firms are rational beings and have a good understanding of the operation of the economy. Both workers and firms can therefore fairly and correctly anticipate the consequences of the economic policies of the Government. Secondly, all product and factor markets are very competitive and hence factor and product prices are highly flexible to bring about quick and rapid adjustments. Figure 2A.5 shows the argument made by Rational Expectations theorists about the relation between inflation and unemployment. The original equilibrium is at point ‘a’ where the initial short run aggregate demand curve AD0 and the short run aggregate supply curve AS0 intersect each other and the equilibrium, full employment, national output OY0 and price level P0 is determined,
given the natural rate of unemployment.

Now when the government adopts expansionary monetary and fiscal policies, the economic units or the factor owners will correctly anticipate the inflationary impact of these policies and make upward adjustment in factor and product prices thereby holding real national output and real wages at their original level.

The shift in the short run aggregate demand and supply curves will therefore be vertically upward as shown in the figure. The economy now operates at the new equilibrium point ‘b’ which is corresponding to the original equilibrium point ‘a’. However, the equilibrium is achieved at a higher price level P1. At every occasion when the Government adopts expansionary policies when the economy is operating at the full employment level of income and output, the aggregate demand and supply curves behave in the same manner and the equilibrium point changes from point ‘b’ to point ‘c’ and so on and so forth. By joining these points, the Long Run Aggregate Supply curve is obtained. Note that the long run AS curve is vertically sloping indicating thereby that once the full employment equilibrium income and output is determined at the natural rate of unemployment, any expansionary policy will only. result in price rise, real national output remaining constant. 

As the long-run aggregate supply curve is vertically sloping at the natural unemployment rate, the long run Phillips curve is also vertically sloping.









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