FIGURE 6 RATIONAL EXPECTATIONS: THE POLICY INEFFECTIVENESS HYPOTHESIS
Rational expectations theory suggests that macroeconomic policy will be ineffective, even in the short term. Assume that the economy is operating at full employment (point a) and short-run aggregate supply curve SRAS0 (P = 100). Now suppose that the Fed announces that it intends to increase the money supply. Expanding the money supply will shift aggregate demand from AD0 to AD1, and this will increase the demand for labor and raise nominal wages. Yet, as soon as the Fed announces it is going to increase the money supply, rational economic agents will use this information immediately to raise their inflationary expectations. Thus, output will remain unchanged, though the price level rises immediately to 110.