According to the rational expectations school, if the Fed announces a policy of rapid growth in the money supply, but then puts the brakes on money expansion without any announcement, which of the following is likely to be the short-run result?
A) an unexpected surge in aggregate demand
B) an unexpected drop in aggregate demand
C) an anticipated surge in aggregate demand
D) an anticipated drop in aggregate demand
E) no change in aggregate demand

Question

Quizplus · Accepted Answer

According to the rational expectations theory, individuals base their expectations on all available information including past experiences and their understanding of how the economy works. If the Fed announces a rapid growth in money supply, individuals may adjust their expectations of inflation and adjust their behavior accordingly, leading to an increase in aggregate demand. However, if the Fed suddenly puts the brakes on money expansion without any announcement, it would be a surprise to individuals who were expecting higher inflation and therefore they might reduce their spending, leading to a decrease in aggregate demand. Therefore, an unexpected drop in aggregate demand is likely to be the short-run result.

According to the Rational Expectations School, If the Fed Announces