Question

Imagine a situation where the government is able to exert control over monetary policy. What happens under adaptive expectations when the government targets a level of output above equilibrium? Is there a short-run trade-off between inflation and unemployment? How about under rational expectations?

Answer 1

Under this situation the government will be controling fiscal and monetary policy both at the same time. Hence it would be hitting output target and inflation target at the same time. Now output cannot exceed its full employment level in the long run. When the government targets a level of output above equilibrium, there is an inflation bias where inflation exceeds its target level. This happens because government must be using fiscal expansion which increases both real GDP and inflation.

Hence when it achieves output target in short run there will be inflation going out of the target. This indicates that there will still be a short-run trade-off between inflation and unemployment. It does not matter whether expectations are adaptive or rational because output ultimately reaches its full employment level. The pace of adjustment will be slow under adaptive expectations, however.