Chapter 4: A Variable Price Level, Supply Shocks and Rational Expectations
4. A variable price level, supply shocks and rational expectations The analysis in Chapters 2 and 3 was carried out with a constant price level. Implicitly we assumed that the aggregate supply schedule was a ﬁxed horizontal line. Whatever level of output was demanded was supplied at the given price level. The focus was on the determination of aggregate demand. In this chapter we include an explicit aggregate supply schedule and allow for a variable price level. Once we allow for a variable price level we must take into account the expectations of economic agents concerning the price level. We also want to allow for shifts in the aggregate supply schedule – so-called supply shocks. After setting out the variable price model in the ﬁrst section, we reexamine the instrument problem considered in Chapters 2 and 3. We go on in the third section to examine optimal combination policies. Finally, in the last two sections we analyze the role that lagged feedback rules can play in monetary policy. THE VARIABLE PRICE MODEL The analysis is carried out within the model speciﬁed in the ﬁrst section of Chapter 2. yt ϭ c0 ϩ c1 (pt Ϫ pe tϪ1 ) ϩ ut, t, yt ϭ where yt pt rt Mt e ptϩj,tϪi ϭ real output, ϭ aggregate price level, ϭ nominal interest rate, ϭ nominal money supply, ϭ expectation of the aggregate price level for period (tϩj) formed on the basis of information at (tϪi), 2 2 ut, vt, t ϭ white noise disturbance terms with variances 2,...
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