Question

Place “MON,” “RET,” or “MAIN” beside the statements that most closely reflect monetarist, rational expectations, or mainstream views, respectively:

a. Anticipated changes in aggregate demand affect only the price level; they have no effect on real output.

b. Downward wage inflexibility means that declines in aggregate demand can cause a long-lasting recession.

c. Changes in the money supply M increase PQ; at first only Q rises, because nominal wages are fixed, but once workers adapt their expectations to new realities, P rises and Q returns to its former level.

d. Fiscal and monetary policies smooth out the business cycle.

e. The Fed should increase the money supply at a fixed annual rate.

Short answer

1. RET.

2. MAIN.

3. MON.

4. MAIN.

5. MON.

Step-by-step solution

Explanation for part (a)

The economists who rely on Rational expectations theory will believe that for the anticipated changes in the aggregate demand, there will be correct anticipation of the changes in the price level and the nominal prices of the inputs. So the producers will adjust the output according to the changed price such that the economy produces at full employment, but the price level changes.

Explanation for part (b)

When the aggregate demand declines, the output price falls. The producers cannot reduce the wages because of wage inflexibility even when the producers are getting a lower price. So, the AS curve does not change. According to mainstream economists, the output shrinks and causes a long-lasting recession because they believe that the economy is not self-correcting but needs a supportive fiscal or monetary policy.

Explanation for part (c)

The third situation is related to the adaptive expectation, which the monetarists support. Monetarists usually hold the adaptive expectations view that people form their expectations by extrapolating from present and past conditions. As a result, they only gradually change their expectations as the experience unfolds like the workers, in this case, adapt their expectations, and because of this, P rises.

Explanation for part (d)

This part is similar to part b, in which the economy does not smoothen as the necessary policy changes were not made. The mainstream economists advocate such policy changes. The RET economics think that the economy is self-correcting. So, any policy is not required according to them. In contrast, monetarists will only suggest monetary policy.

Explanation for part (e)

The FED should increase the money supply at a fixed annual rate is the monetary policy rule given by a prominent monetarist Milton Freidman.