Rational Expectations:

Our picture of the determination of real GDP as well as unemployment under sticky prices is now complete. We have a complete framework to understand how the aggregate price level and inflation rate move and adjust over time in response to production relative to potential output, changes in aggregate demand and unemployment relative to its natural rate. There is nevertheless one loose end. How does one obtain from the short-run sticky-price patterns of behavior that have been covered in Section IV to the long-run flexible price patterns of behavior that were laid out in Section III? How do you obtain from the short run to the long run?

In the case of a predictable shift in economic policy under rational expectations the answer is straightforward: you don't have to obtain from the short run to the long run the long run is now. An inward or else outward shift in the monetary policy response function on the Phillips curve diagram caused by an expansionary or contractionary change in economic policy or the economic environment sets in motion an offsetting shift in the Phillips curve. In the lack of supply shocks:

Π = Π^e - β x (u - u*)

If expectations are rational in addition to if changes in economic policy are foreseen, then expected inflation will be equivalent to actual inflation:

Π = Π^e

This signifies that the unemployment rate is equal to the natural rate the economy is at full employment.

Under Rational Expectations, the Long Run Is Now…

Legend: Under rational expectations there merely is no short run unless changes in policy come as a complete surprise.

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