ECON 2 Lecture Notes - Lecture 30: Lucas Critique, Adaptive Expectations, Classical Dichotomy
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15 Sep 2020
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Suppose the economy begins in steady state and policymakers decide to lower the target rate of inflation. The new rule calls for an increase in interest rates. The economy must now move to its new steady state. When actual output equals potential output, the new steady state is at the new target rate of inflation. The change in the rate of inflation causes the as curve to shift during the following period. Firms adjust their expectation for inflation to account for the new lower inflation rate => the as curve shifts down. The inflation rate is still above the target, so the central bank keeps actual output below potential. Eventually the economy will rest in its new steady state. Note that if the classical dichotomy holds in the short run, the ad and as curves would reach the new steady state immediately. If there is sticky inflation, a recession is needed to adjust expectations down.
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