Assume people expect money supply to rise by 10% but the Fed allows money supply to rise only by 5%.What will be the short-run effect under the Lucas model of rational expectations?

Question

Quizplus · Accepted Answer

According to the Lucas model of rational expectations, people will anticipate the increase in the money supply to be 10%. As the actual increase is only 5%, people will realize that their expectations were too high and adjust their behavior accordingly. This means that both output and prices will be affected. Since people now anticipate a lower increase in the money supply, their demand will be lower, which will lead to a decline in output. However, prices will increase by less than 10% because people will not be willing to pay as much for goods as they would if the money supply had actually increased by 10%. Therefore, output will decline and prices will increase by less than 10%. Choice A is correct.

Assume People Expect Money Supply to Rise by 10% but the Fed