Under rational expectations and no nominal rigidities, aggregate output is sensitive to ___________ supply and ___________ demand shocks.

a) Anticipated, anticipated
(b) Anticipated, unanticipated
(c) Unanticipated, anticipated
(d) Unanticipated, unanticipated

My attempt: The answer is (d) unanticipated, unanticipated
There is no nominal rigidity, so an expected demand shock would lead to a change in expected prices. Both Aggregate Demand and Supply curves would move so that output remains at full employment. All real variables will remain unchanged.
So only an unanticipated demand shock would cause output to change in the short run.
On the supply side, only unanticipated shocks would cause changes in output, eg. sudden increase in oil prices.

  • $\begingroup$ Hi: I've been teaching myself this material and you're correct on unanticipated supply. See Shefrin's text "rational expectations: for a really nice explanation of this concept. It's the best graphical explanation of this natural rate concept that I've seen. The demand shock part I'm not sure of because sheffrin considers the example of an increase in money supply which is a supply shock. $\endgroup$ – mark leeds Feb 25 at 2:48
  • $\begingroup$ Hey, thank you so much. I'll look into Shefrin. Isn't a change in money supply a demand shock? It causes the Aggregate Demand curve to shift. $\endgroup$ – Chetna Ahuja Feb 25 at 6:40
  • $\begingroup$ You might be right. I always get confused on this concept. My understanding is that the increase in money supply, increases price level and there is movement along lucas supply curve when price changes. But I could be wrong. Hopefully others more knowledgable will chime in. In fact, if you read Sheffrin, maybe you could explain it. It's Chapter 2 from pages 25-40. $\endgroup$ – mark leeds Feb 25 at 18:42
  • $\begingroup$ just to continue above. the movement along the supply curve doesn't happen because the expectation of the price increases ( because people associate inflation with higher prices ) so the demand curve shifts due to this vertical change in price expectation of the agents. So, the intersection of the AD and AS occurs at a point of higher price but not greater output. This is all in sheffrin but I get confused with what the shock actually is when the money supply increases. $\endgroup$ – mark leeds Feb 25 at 22:50
  • $\begingroup$ Chetna: It's also explained quite nicely in 391-402 of the linked paper below. Unfortunately, I'm still not clear on how that translates to the answer to your question. nber.org/papers/w1224.pdf $\endgroup$ – mark leeds Feb 26 at 17:41

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