2)New classical contribution

Rational expectations theory: people base expectations of inflation on the current information and personal evaluation of the gov policies and promises.

Modification of Phillip’s curve: both in the s-r and l-r Phillip’s curve is vertical

P=f(1/U)+Pe, where Pe are rational expectations (when people correctly predict the rate of inflation and don’t expect any changes in national output). On average, predictions are correct.

The new classical economists assume that markets clear virtually instantaneously. There is thus no disequil unempl, even in the s-r. All unempl is equil unempl, or voluntary unempl (people do not work due to lack of incentives to do so).The new classical theory is based on rational expectations which is imperfect. These errors in predictions are random. People’s predictions of inflation are just likely to be too high as too low.

If expectations are correct: people will rationally predict thet output and unempl will stay at natural level. They predict that any change in aggregate monetary demand will be reflected purely in terms of changes in prices=> AD remains the same=> if it is the same=>so will the demand for supply of labour and the demand for and supply of goods. Thus, even in the s-r, output and unempl will stay at the natural level.

People under predict the rate of infl: workers will believe that they are getting a higher real wage than they really are=> they will supply more labor (Q1 rises to Q2) If only labour (and not firms) under predict the rate of infl, this rise in empl to Q2 is the only short-run effect.

If firms under predict infl rate too: 1) they will want to produce more=>demand for labour will tend to increase 2)but they will believe that any given level of money wages represents a higher level of real wages than it really does. They will tend to employ fewer people at each wage rate, and demand curve will shift to the left.=>depending on which way the demand curve shifts, firms could employ more or less than Q2.

If people over predict the rate of infl, employment will fall as workers believe that their real wage is lower than it really is and therefore work less; and output may well fall as firms believe their product’s relative price has fallen.

Under prediction of infl shifts the s-r Ph curve to the left (AS to the right) as unempl temporarily falls below the natural level (output rises above its level). Over prediction shifts the Ph curve to the right (AS to the left).

According to rational expectations theory the real and the only result of any gov activity will be inflation.

Policy implications:

1. elimination of inflation may be effective only if gov provides non-demand monetary policy (f.p. is ineffective; m.p. may be effective only if it’s aimed to encourage AS)

2. AD stimulation is nonsense, the only result of this policy is inflation accelerated by RE

Modern Keynesian contributions

Basic hypothesis: both adaptive and rational expectations take place but they concern not only price level tendencies, but also output and employment tendencies.

Modification of Phillip’s curve:

• in the l-r the Phillip’s curve is more inelastic than in the s-r, but is not vertical

• if gov-t increases AD the result s will be 1) strengthen of inflation due to both adaptive and rational expectations 2) reducing unempl, because people expect boom and therefore begin to consume more

Policy implications:

AD reduction in order to fight inflation is ineffective because:

1. it has weak effect on inflation due to wages and prices inflexibility

it has a large effect on unempl and ec.growth because in the period of unempl people become unskilled.

Explanation of stagflation

Monetarists’ explanation is based on clockwise Phillips loops.

Assume that gov wants to reduce unempl, for ex increasing gov exp. Economy will move through point B to C, and in point C gov begins to worry about high rate of inflation and allows unemployment to rise again in order to decrease inflation rate, but infl still rises due to expectations=> economy moves from point C to point f. This is the situation of stagflation -term used in 1970^s to refer to combination of stagnation (low growth and high U) and high inflation. Decrease in r rate and finally it will be disinflation. The only country which testified this theory is Russia at the beginning of 1990^th. This policy leads to end of any government.

Possible way to overcome stagflation: to allow U rise further.

Modern Keynesian explanation is based on the rightward shifts in the Phillip’s curve due to growing monopoly power of firms and trade unions; and growing equilibrium unemployment at the same time.

• rightward shift of Phillips curve is caused by increase in cost push inflation due to keeping high prices by monopolists and high wages

• another shift is caused by increase in equilibrium unemployment due to changes in technology and competition from abroad.

Final results: shift from A to B (both infl and unemployment) is stagflation.

The possible ways to overcome stagflation(allow Phillip’s curve to go back)

1)price and income policies (cutting prices and wages at the same time)

2)improvement of information on the labor market in order to diminish equil unemployment

3)pro-competition policy - antimonopoly and anti unions

4)supply-side policy(policy to encourage AS)